Liquidity, the Challenge of Returning to Normal

This is a difficult time for monetary policy, which is facing several challenges. Some are structural and strategic. One example: the ability to control the rate of inflation in a timely manner has been made uncertain by the experience of recent years. Another example: the independence of central banks from the financing needs of governments has been questioned, though this is at the basis of their credibility.

But the most urgent challenge is cyclical, tactical. It is normalization. Over the past decade, to remedy the financial crisis that started in 2007, monetary policy has resorted to unconventional instruments, such as quantitative easing, inundating the economy with liquidity and bringing interest rates to very low and negative levels. In addition to directly stimulating real growth, unconventional policies have made intensive and unorthodox use of forward guidance, i.e. forewarnings and commitments on their future (expansive) policies, to influence market expectations and to have an indirect effect on the economy through them.

The large and widespread increase in liquidity and low interest rates have not only stimulated increases in prices and production, they have also had collateral effects on bond and equity values, as well as on the risk appetite of investors and intermediaries. Stock exchanges had what some would consider speculative bubbles; looking for profitable uses in a world of very low rates increased the riskiness of portfolios and intermediaries. There is a risk that these bubbles will burst and that the risks will turn into mishaps and insolvencies, which may then multiply due to panic and contagion. Some may fear that, in a world economy that has resumed growth in real terms, the financial crisis could return.
Central banks have therefore scheduled a gradual decrease in the intensity of expansive stimulus and a return to the use of more orthodox instruments: returning to a world of positive rates that can be maneuvered in a textbook manner, lower when the economy and prices slow and higher when they overheat. Both the decision and the implementation of these normalization projects are at various stages in the various central banks: more advanced in the US, less so in Europe and even less in Japan. But the challenge of normalization is present everywhere.

Why is this a challenge? Because it is not easy to return to normalcy. There are technical issues in reabsorbing liquidity. But the relationship between markets and monetary authorities is especially difficult. Announcing less expansive or even restrictive policies could cause panic, sharp falls in the stock market and traumatic abandoning of risky investments. Though world liquidity is currently overabundant, a true beginning of drying it up should be managed with caution. This is true in part because, as mentioned before, influencing expectations by announcing future decisions is at present considered a consolidated method of carrying out monetary policy. A change in the tone of monetary policy also implicates a careful dose of announcements from central banks: they too need to change. But they should not contradict past announcements too much so as not to compromise the credibility of those who make them. They must change without alarming and without surprising, assuring that more normal rates and liquidity will go hand in hand with the normalization of the economic cycle and a final exit from a long period of macroeconomic tensions.

In addition, large central banks must be able to normalize without getting in each other's way, preventing the various paces of normalization in the various monetary areas from creating extreme differentials in interest rates, large instabilities in exchanges and distortions in the competitiveness of exports.

Perhaps the orthodox and widespread idea that there is no need to coordinate monetary policy should be abandoned.