Morgan Stanley: Global What Will Tightening Look Like?

By Manoj Pradhan | London

Even before the dust settles on the monetary easing cycle, markets have started a watch for the beginning of monetary tightening. Unlike past cycles where the focus was solely on policy rates, the unconventional element of monetary easing means that the assets and liabilities of central banks are key variables in the tightening equation. Central bank balance sheets will undoubtedly be observed as closely as indications of policy rate hikes. But we caution investors against equating a contracting balance sheet with a withdrawal of monetary expansion. Instead, we provide a laundry list of measures that would constitute monetary tightening. None of these measures indicate that tightening is imminent any time soon.



In This Issue
Easing still not easing up. The BoE fired a shot across the bow last week by announcing an additional £50 billion to purchase government securities as part of its ‘active' QE programme. (‘Active' QE purchases refer to purchases made via the MBS or Treasury purchase programmes run by the Fed or the APF run by the BoE. ‘Passive' QE refers to an expansion of balance sheets via the various liquidity programmes. For more details, see "QE2", The Global Monetary Analyst, March 4, 2009.) The Fed, the ECB and the BoE have around US$700 billion, €55 billion and £50 billion, respectively of asset purchases to go to reach their current targets, with a possibility that these programmes could be extended further, in line with the BoE's actions. At its current pace, the Fed's asset purchases are likely to end around December 2009, just a month before the FOMC meeting for which markets have priced in 25bp of rate hikes. And it is not just in the US, euro area, UK and Japan that monetary expansion is still underway. Central banks are still cutting rates in the CEEMEA region while fixed exchange rate regimes are facilitating the import of monetary stimulus from the major economies. Of particular interest is the case of China, where this imported monetary stimulus is adding to a large, domestic monetary and fiscal stimulus package. Turning such an extensive policy expansion around quickly is neither salutary nor easy, and central banks will likely tread with caution as they map uncharted territory in unwinding QE. While the monetary tap remains open, excess liquidity continues to remain extraordinarily high, providing support for risky assets and economic recovery (see "The Global Liquidity Cycle Revisited", The Global Monetary Analyst, May 27, 2009).

Central bank balance sheets will become a focus in the process of unwinding QE. We intend to monitor these balance sheets on an ongoing basis. Some central bank balance sheets (notably that of the Fed and the ECB) have already started contracting. However, investors should not take that to be a sign of withdrawal of monetary stimulus.

Rather, passive QE programmes - liquidity programmes whose size was largely determined by the needs of financial institutions - have become smaller in size as markets have started to function again and provide financial institutions with better terms (see "Fed Exit Strategy: When and How", The Global Monetary Analyst, June 24, 2009, and "QExit", The Global Monetary Analyst, May 20, 2009). Thus, far from indicating some tightening by central banks, we believe that any contraction in the balance sheet due to lower demand for liquidity assistance from central banks actually means that monetary easing will be better delivered to the wider economy, since healthier financial markets mean a more robust transmission mechanism for monetary policy.

At the height of the financial crisis, financial institutions used liquidity lifelines extended by central banks extensively. They preferred, though, to park the funds with central banks in the form of reserves, given the extreme uncertainty not just regarding the economy but also about their own financial health. Conditions are quite different now. Surveys of lending standards suggest that commercial banks are becoming less reluctant to lend. This implies that a larger proportion of funds at the disposal of these banks could find its way into the economy rather than languishing on the books of central banks. This would effectively reduce bank reserves and the size of the central bank's balance sheet and lead to an increase in M1. Again, a contraction in the balance sheet of central banks driven by this trend would be a salubrious development rather than a sign of monetary tightening.

So what would monetary tightening look like? Monetary tightening could take any or all of the following forms: (i) allowing lending rates to drift higher, or encouraging such a move with hawkish talk; (ii) stalling an expansion in money supply; (iii) contraction of the central bank's balance sheet, driven by the unwind of ‘active' QE programmes; and (iv) policy rate hikes.

In summary, only the first measure of monetary tightening shows any risk at the moment. Convincing guidance from central banks about their plans for unwinding policy easing will likely deflate this risk. On all other measures, monetary tightening is likely to be weaker than markets currently anticipate. Having worked so hard to engineer a recovery, it is difficult to see why central banks would aggressively tighten policy, risking a strong adverse reaction from markets and putting the fragile medium-term outlook in jeopardy.