Walking the tightrope: what will happen when central banks retreat

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Central banks’ imminent retreat from the unprecedented monetary easing adopted following the financial crisis could lead to a severe loss of confidence in the markets, economic contraction and deflation — not just inflation as many fear. Sherif Lotfi, Head of Corporate Advisory, Americas, and Edward B. Marrinan, Head of US Macro Credit Strategy and Co-Head, Markets Strategy, Americas, at RBS explain.

The range of monetary easing programs introduced around the world since 2008 has led to intended and unintended distortion across the financial markets and wider economy. What was originally designed as an unconventional and temporary response to spur economic activity has become a protracted monetary policy for developed economies. We have seen low demand for loans and regulatory pressure on banks to hold more capital and liquidity. This means the extra cash pumped into the system when central banks bought troves of securities has ended up back with the central banks as excess reserves — failing to filter through to the wider economy. Monetary easing has not had the full effect the central banks hoped for – their actions have been akin to sprinting hip deep in mud. Alongside quantitative easing (QE), monetary easing policies include lowering benchmark rates to nearly zero – known as ZIRP (Zero Interest Rate Policy), providing various liquidity programs targeted at specific markets and adding interest on reserves. QE was designed to push investors away from cash or government bonds and toward private sector capital – loans, bonds and equities. While the central banks have lifted the value of these so-called ‘risk assets’ by lowering base rates to offset unusually high risk premiums, their actions carry significant risk too. Potential consequences include a credit bubble, commodity price volatility and currency wars. Meanwhile, the yield compression created by QE is herding retail investors toward a new crisis when rates inevitably rise – unless the central banks can navigate the exit without an asset collapse or rapid inflation. It’s like walking a tightrope across the Grand Canyon. The longer such policies remain, the more distortive they become. Central banks’ ability to retreat successfully as the economy heals depends on how well banks can deploy their balance sheets, the influence of demography and technology, and the extent to which new regulation inhibits cross-border capital flows. There are three potential outcomes. Successfully walk the tightrope Since many of the assets they purchased are relatively short duration, central banks do not have to sell a huge portion of their securities to absorb excess money as the economy recovers. They can allow assets to run off and manage liquidity as banks deploy, using their excess reserves as the economy heals. Fall off the tightrope at the beginning A fragile recovery is laid to waste by anticipated interest rate increases from a sudden bursting of the fixed income asset bubble, economic contraction and deflation. We see either a severe loss of confidence that central banks’ unconventional policies cannot overcome, or an over-contraction in monetary policy in response to rising inflation. Fall off the tightrope at the end The economy heals much quicker than anticipated and the central banks are not able to reduce the excess money supply fast enough without a severe shock. We end up in a period of prolonged inflation which erodes the value of long duration assets and liabilities, reduces margins and increases volatility. The first scenario is highly optimistic. Falling off the tightrope would put us in a prolonged period of negative or stagnant real return on all asset classes. Long-term fixed assets would obviously get hit harder with higher inflation. Lower real asset returns will slow real consumption growth – a price we will all pay for the excesses of the past. Companies need to consider this uncertain future when positioning their balance sheets. This means addressing additional factors. Can they pass some of their cost inflation to customers? How flexible is their cost structure? Is their industry open to further consolidation? Are there acquisitions which can enhance their technology base or expand their customer offering? Given the breadth of corporate business models and range of potential macroeconomic outcomes, there is no one-size-fits-all response, yet most companies can benefit from more flexible balance sheets. For example, a cyclical manufacturer’s capital expenditures are large and lumpy with demand based on global GDP and derived from spending on capital goods. The manufacturer will need substantially more flexibility than a consumer goods company which has more modest and adjustable capital expenditures despite facing a very competitive environment. The consumer goods company will need flexibility to handle margin erosion while still investing in brands, product development and opportunities to acquire brands from those challenged to invest during a contraction. A natural resource company faces commodity price cycles which can be volatile, as well as less cyclical production costs. It needs sufficient flexibility to manage the heightened risks from over-expansion, which are magnified by macro-uncertainty. At the same time, the company would benefit from the ability to acquire properties during contraction or before an inflationary period but manage exploitation to more profitable portions in the cycle. Whatever the company or sector, it is difficult to over-estimate the impact pulling the plug on monetary easing will have on the economy. Businesses need to think carefully about the possible outcomes, and what effect they will have, and prepare accordingly. 

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