Past Salons 21st Credit Suisse Salon

21st Credit Suisse Salon

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Janet Yellen: “A trade war could lead to a shallower path of rate hikes.”

In an inspiring conversation, Sir John Major, former UK Prime Minister, and Dr. Janet Yellen, Chair of the Board of Governors of the Federal Reserve System from 2014 to 2018, discussed what lies ahead for central banks and monetary policy.

In the course of quantitative easing, the Fed bought something like 4.5 trillion dollars worth of bonds. What were the difficulties in unwinding that?

 

What we worried about was that beginning to run down our balance sheet would create enormous disruptions in financial markets and that we would see a great deal of volatility and perhaps a spike in long-term rates. And I think we had good reason to worry about that: In 2013 the Fed was still buying 85 billion dollars worth of treasuries and mortgage-backed securities a month. In June it announced that, if the economy continued on track with respect to employment and inflation, later that year it would probably begin to scale back the pace of purchases. And what happened was that long-term yields over the next month or so spiked over 125 basis points. Not only was that disruptive to the US recovery and totally unanticipated, it also put enormous pressure on many emerging markets. Quite a few countries around the world saw huge capital outflows. Their currencies were under pressure, they had to raise interest rates enormously. That episode was called the taper tantrum.

How did you avoid prompting that kind of volatility again?

 

We wanted to understand what had happened in 2013 and found out that the Fed’s announcement that it would likely scale down the pace of purchases had triggered an expectation that it would also start raising short-term interest rates pretty quickly after that. And that was a much more hawkish shift in market expectations. So, when we began to embark on the process of unwinding, we made it very clear that there was no strong link between our beginning the process of running down our balance sheet and raising short-term interest rates. We made it very clear that we had no intention of selling assets, but that we would gradually lower our asset holdings by taking principal that was coming due and, instead of reinvesting all of it, we would gradually begin to redeem some. We said that, slowly, over a period of somewhat over a year, those caps would rise, but they would be kept at 50 billion dollars a month. The level of redemptions has risen several times since then and is now close to 50 billion. At no point did we see any adverse market reaction. We’ve also made it clear that we do not see the level of run-down in our asset holdings to be anywhere near 4.5 trillion dollars. My guess is that something closer to 1.5 trillion is more likely, but no final decisions have been made about what the size of the balance sheet should be.

If you don’t fully unwind how would that affect your toolbox in the event of a similar problem occurring in the future?

 

In principle it shouldn’t affect our toolbox. There’s no obvious limit to the scale that the central bank’s balance sheet could be. It reached 4.5 trillion. Could it reach 6 trillion? Sure. Could it reach more than that? There’s no inherent logical reason why not. But I would say that, politically, these asset purchases have been very sensitive. They’ve put the Fed under a great deal of political pressure. And having a balance sheet that large which is that leveraged means that the Fed’s income could become quite variable. Now, the purpose of a central bank is not to make money on its operations, but it could become politically quite sensitive if the Fed were to make losses. There would certainly be reluctance to take the Fed’s balance sheet up to extremely high levels. And so, yes, it may be limiting in terms of future ability to make asset purchases if the Fed’s balance sheet doesn’t shrink substantially.

One of the problems right at the outset of this was the security of the banking system, which led to the Dodd-Frank reforms. How successful have these reforms been?

 

We had a very unsafe and unsound banking and financial system in the run-up to the crisis. The Dodd-Frank reforms and the set of reforms that we’ve had around the globe, in part facilitated by consultations in the Basel Committee and the Financial Stability Board, mean we have a much safer and sounder banking and financial system. We have more capital, we have higher quality capital, and more liquidity requirements so that firms are able to endure an outflow of short-term funding and have enough liquidity on hand to manage that. Importantly, we have agreed that the most systemic banking organizations need to have more capital than other banking organizations because their failure could impose very significant consequences on the financial system. And even outside of banking we’ve made reforms to derivatives so that standardized derivatives are now centrally cleared, we have higher margin requirements on those that are not cleared, and in the US we have put in place reforms of money market funds. All of this is significant and it has resulted in a safer banking system.

President Trump has begun to unwind some of the regulations …

 

We need appropriate regulation and I would not want to see us forget the lessons of the crisis. I’d say it has not happened yet though. It’s not a bad thing to review and make adjustments where regulation has had unintended consequences. And I think the bill that was passed and signed by President Trump largely does that and does not threaten the core of what was put in place. But deregulation could go too far in the US and I do very much worry about that.

How did you avoid prompting that kind of volatility again?

 

We wanted to understand what had happened in 2013 and found out that the Fed’s announcement that it would likely scale down the pace of purchases had triggered an expectation that it would also start raising short-term interest rates pretty quickly after that. And that was a much more hawkish shift in market expectations. So, when we began to embark on the process of unwinding, we made it very clear that there was no strong link between our beginning the process of running down our balance sheet and raising short-term interest rates. We made it very clear that we had no intention of selling assets, but that we would gradually lower our asset holdings by taking principal that was coming due and, instead of reinvesting all of it, we would gradually begin to redeem some. We said that, slowly, over a period of somewhat over a year, those caps would rise, but they would be kept at 50 billion dollars a month. The level of redemptions has risen several times since then and is now close to 50 billion. At no point did we see any adverse market reaction. We’ve also made it clear that we do not see the level of run-down in our asset holdings to be anywhere near 4.5 trillion dollars. My guess is that something closer to 1.5 trillion is more likely, but no final decisions have been made about what the size of the balance sheet should be.

To what extent does the Fed consider the impact on the rest of the world when making its decisions?

 

By law the Fed’s objective has to be domestic goals. It would not be acceptable to congress for the Fed to say: “We took action to help other countries that hurt the US.” However, international considerations matter a great deal. Economies are linked both through trade and global capital markets. Developments in the rest of the world are very important in driving US outcomes. And financial market disruptions that may originate in other parts of the world have spillovers, and US monetary policy has spillovers to other countries. So even if the people in the Fed were taking the narrowest possible view and focused just on the self-interests of the US economy – which they’re not, they really do care about the rest of the world – they would have to worry that US monetary policy has impacts on the rest of the world, which spill back.

There’s a widespread perception that America under President Trump is retreating significantly from its predominant international role.


I wish I could tell you where US policy is going to go under the Trump administration. But I am very concerned about what I would also regard as a US retreat from its traditional role. We’re seeing a huge retreat from the principles the US has espoused and all the institutions that we built in the postwar period. Resisting protectionism and strongly supporting a rules-based multi-lateral system are what the US stood for and promoted as a global system with great success. And I believe that system is responsible for great improvements in growth and well-being around the globe. But, this is a set of principles that the US has walked away from and has been unwilling to endorse. There are some valid trade issues with China, and perhaps with Europe, but we’ve always approached dealing with these issues in an orderly way respective of WTO principles and long-established principles of trade. And it greatly worries me to see the US taking bilateral approaches and unilateral action. I don’t think much has happened yet, but certainly the level of tension is escalating and the retreat goes further; it’s not just a matter of trade. This is a very worrisome development.

How would central banks react if the present trading problems turned into a significant trade war?


In terms of the real damage that a global trade war would do to our economies, there’s absolutely nothing that central banks could do to repair that. But central banks – including the Fed – would do the best they could to try to achieve their mandates, which in the US case is low and stable inflation around two percent and keeping the economy operating at full employment. Escalating tariff barriers would probably tend to boost prices, so they would be inflationary in the US and I suppose also in countries that retaliate, and that might lead to tighter monetary policy. But frankly, I wouldn’t make too much of that because, with well-anchored inflationary expectations, the increase in price that you would see from a host of tariffs going into effect would be transitory and something that would die down. The Fed's typical response to that type of temporary inflation shock has been to look through it and not respond. The more important thing is that trade tensions create an enormous amount of uncertainty for businesses, with almost daily drops in the stock market that have a depressing effect. That uncertainty can lead to investment being postponed or possibly cancelled. The overwhelming thing we would see would be weakness in the economy and, if anything, that would prompt central banks to respond with a shallower path of rate hikes or even with rate cuts.

Is a trade war more likely to impact monetary policy from a growth or from an inflation perspective?


I think the answer is a growth perspective, but I’m not sure. The Fed is unlikely to do anything preemptive or forward looking with respect to trade. There’s simply much too much uncertainty. If this really does escalate into something with significant economic consequences, then I guess it will push up inflation, but just for a time. The growth consequences would probably be more important. Our trade restrictions on China could affect much of Asia which is linked to China through global supply chains. This could lead to a slowdown in global growth. And my guess is that it's negative for the real economic outlook and that it's going to be the more important thing for monetary policy.