2017 Financial Markets Conference—Raghuram Rajan Keynote—The Exit from Accommodative Policies: Prospects and Challenges

Raghuram Rajan from the University of Chicago Booth School of Business opened the conference and commented on the effects of unwinding quantitative easing.


Raghuram Rajan: I was wondering what level I should speak at, because this is a topic which you can get into the trenches and have a debate about the technical issues in each of the aspects of unconventional policy. Or you can have a discussion at a 60,000-feet level of the broad issues involved. So I'm going to do a little bit of both today and see whether I can keep the significant others from outside the banking industry who are here awake—at least for the duration of the talk.

We all know that we've been in a period of extremely accommodative policies—that itself could be called unconventional in some sense—but we've also had a lot of innovation among central bankers in terms of policy. So if you just read through the list of things that have happened across central banks in the world, we certainly started with something which looked a little more conventional but had the imprint of a difference: the "low for long" policies. Then forward guidance, to try and make sure that this was really believed by the markets. Then a whole set of policies in refinancing, with various acronyms—for example, the LTRO—long-term refinancing operations, conducted by the ECB [European Central Bank]—various forms of QE [quantitative easing]: QE, QQE, et cetera, et cetera. Negative interest rates: we have this new policy of yield-curve targeting by the Bank of Japan. And of course, the good old exchange rate targeting, which has resurfaced for example in the Swiss National Bank.

So the questions that I want to ask in the talk today are, one: Why were they used?—and some obvious answers, and some not so obvious answers. Second: Did they work? Third: What happens as they are unwound? Fourth: What long-term concerns do they raise beyond the unwinding? And fifth—and perhaps I'll leave this as speculative—do they actually compromise the independence of central banks? I'll try and say something on all these issues as we go along.

So, why were they used? Of course, we know that in the immediate aftermath of the crisis there were a number of markets that were frozen, where there was actually no intermediation taking place, no activity. And clearly, one of the goals of these unconventional policies—whether it was QE1 or the securities market program run by the ECB, OMT [outright monetary transactions], which never actually ran but was announced, and LTRO—all these things were useful to repair markets that were broken. I think that's pretty clear, and I think it's reasonable to say that they did have that effect.

But then there was also the problem of having reached the zero lower bound in interest rates, and so what the various central banks wanted to do was create instruments that could affect yields of prices when the short-term interest rate was pretty close to zero. They were obviously trying to target short-term yields over time—that's in a sense the "low for long," or forward guidance—but also directly hit long-term yields by intervening in long-term bond markets. And of course, one of the big prices that sometimes is [seen] to be effective is the exchange rate. These instruments, apart from directly affecting the price, also seem to convey fairly strong signals, helping the central banks send the signal that we are going to be as accommodative as possible, and we're going to be as innovative as possible, to find new tools if the old tools don't work.

Every central bank kept saying, "I'm doing this today, but trust me: I can do more if necessary." Whether they should have been believed by the markets is a different question, but it was always: "Trust me—I have another tool behind my back, which I'll bring out at the right time if this doesn't work." But some of these instruments did have the effect of basically signaling that they were intent on keeping, for example, interest rates low for long. So some forms of QE, especially if announced over time, sent to the market the signal, "We're not going to raise interest rates until we're done with this process, at least. So until we actually tell you that we're going to stop this QE, believe us: the interest rate is going to remain at zero." Right? So that was another way of adding weight to the commitment to stay low for long.

And finally, as we're going through the reasons for why they were used, we have to understand that the mandates of central banks—at least, many of the central banks in the industrial world—came at a time when the big problem was high inflation. Inflation targeting was in many ways an attempt to bring inflation within bounds, and we knew that we had the instruments for that, certainly after Paul Volcker showed the way to bring inflation down.

What we were less equipped for, as central bankers, is to deal with interest rates below the lower bound, right? We didn't quite know how to deal with it, but it was a mandate. And while we were below the lower bound, no central banker could say, "I've run out of tools, I don't know what to do. I really don't know how to get the inflation rate up." And so, in some sense, they had to do stuff. Whether they worked or not didn't really matter. They had to be seen as active.

I threw this out as yet another reason that they just couldn't stop and say, "I've run out of tools. I've reached the zero lower bound. There's nothing more I can do." And therefore we came up with all these other innovative—I won't say this is the central reason, I'd say this is one of the reasons: [it's] very hard for somebody to say, "I really don't know how this this is going to work."

So, let's take the next question that I said I'd address: Did these various interventions work? And I'll offer a "Clinton-ism" here: depends on what the meaning of the word "work" is. [laughter] Right? For sure, these actions helped stabilize markets. I think the mortgage-backed securities, for example, with the Fed intervention, certainly sent the signal that there was a buy in the market, certainly sent the signal that the Fed was probably behind these mortgage-backed securities and seemed to help revive those markets, and I think all the evidence points in that direction.

Similarly, one could argue that the ECB played an enormous role in preventing the default of periphery countries—remember, there was a time when Italian bonds were up at 7 percent, Spanish bonds were there. And I think the ECB was saying, as Mario Draghi famously said, "We'll do what it takes, and believe me—it will be enough." I think that was a very strong signal, backed by various instruments. As I said, one of the instruments was—they just said, "We can bring it out." But I don't think they ever used it—the OMT, the ordinary monetary transaction. It was essentially conditional lending to the periphery countries. They never had to use it. It was enough because the spreads narrowed for those countries.

So in that sense, in reliquefying markets—reviving markets—that had shut down, I think these unconventional policies were in fact quite good. Certainly they reinforced the notion of the central bank as fully committed to its mandate and innovative. And in that sense may have prevented worse outcomes. Of course, it's hard to know how to test that, but it is quite possible, for all the reasons we talked about, that it might have helped.

And then there are a ton of studies which are emerging which show that they did affect prices, at least in the very short term. Certainly the work of Arvind Krishnamurthy at Stanford and Annette Vissing-Jørgensen at Berkeley suggests that there was a signaling element, for example, to the QEs. They did suggest that, in fact, the Fed would tighten later, because there was a mass of quantitative easing that had to be done before the Fed embarked on monetary normalization. So that date was pushed back every time the Fed announced more QE.

As I said, the default risk in certain securities might have been reduced by Fed intervention in the mortgage back or by ECB intervention. But government securities—remember, for some countries their banks held 30-40 percent of their own government securities in their portfolio, so the narrowing of those spreads had the additional effect of also increasing mark-to-market capital of those banks, which helped prevent a downward spiral in those countries.

The direct effect of some of these policies like QE was supposed to be the portfolio balance theory. For those who are not familiar with it, let me put it simply as the Fed takes out long-term bonds from the market and gives back short-term reserves. What that tends to do is essentially increase the price of long-term securities or reduce the yield of long-term securities. The hope is this transmits more widely into the markets, reduces long-term interest rates, and allows for more investment.

Well, we know one part of it seems to have worked. The instruments that the central bank intervened in, those seem to have gone up in price as they remove from the market. It seems as if people who were clienteles in that particular instrument went and bought more of that when the Fed took it out, to replace what the Fed had taken out. And that increased the price of those instruments. Harder to find a more generalized effect—though there are some studies I will argue, in a moment, that argued there was—harder to find a more generalized effect across the markets.

There are some, however, studies, as I said, which say that it went beyond this. So some studies, for example, argue that with the Fed having pushed down long-term interest rates, it was possible for lower-grade corporations to go out and issue long-term securities, and that helped investment. But there are relatively few studies which essentially take the leap from interest rates for a narrow set of securities—such as government bonds—to a broader interest rate environment in the economy, to actual investment. There are a few studies, I want to say, but they're few and far between.

So, if you sum up these effects, they're there, but they don't seem to be particularly strong. What we don't know is what would have happened if the central banks...what is strong is the repair of the markets, but about sort of reenergizing economic activity, the effects are much weaker. So the question is, we don't know what would have happened if the central banks hadn't intervened. Would we have gone into a deflationary environment, with spiraling deflation, which would then have caused a cataclysmic problem in the economy, given how levered many of these economies are? We don't know that. We don't know if, through these actions, the Fed or the ECB managed to contain inflationary expectations at a reasonable level, prevented them from plummeting, and as a result helped boost activity.

But there are effects that we do know about, which had potentially adverse spillover effects. One is, of course, every monetary action typically has an effect on the exchange rate. What studies suggest is the effects close to the lower bound were in fact larger, that there were more effects in the exchange rate. So typically, when a country cuts interest rates, we think that it increases domestic demand in the country because there are more interest-sensitive consumers who go out and buy. There's more investment that takes place. So domestic demand grows up, but also—because interest rates in the country are lower—the exchange rate falls. And as a result, the country also sells abroad a little more. You're sort of taking, in a sense, demand from other countries.

Now in general, with ordinary monetary policy, other countries should not mind because the increase in domestic demand more than compensates for the demand shifting from across countries, and in general it's a reasonable thing. But in a period where your interest rate-sensitive sectors are not responding—as, for example, when interest rates are really low and a lot of your interest rate-sensitive sectors are very highly indebted—the domestic demand effects of monetary policy are relatively small. The demand-shifting effects of monetary policy are potentially larger. And that is something that studies increasingly are seeing—that in fact one of the contributions to domestic activity was essentially through the exchange rate, that exchange rates weakened for countries that engaged in aggressive, unconventional monetary policy, and this had greater effect near the zero lower bound. There's an ECB paper which recently came out on this.

And the last aspect, of course, is that accompanying this exchange rate effect is a capital flow effect—that as you have very accommodative monetary policies in the industrial countries, you send out capital flows. And those capital flows have to go somewhere. Typically they go to places with higher yields. Typically, those used to be emerging markets. And so you see both the counterpart of the depreciation of industrial country currencies is an appreciation of emerging markets as well as a narrowing of their current account surpluses—in fact, they've turned to deficit over this period. The emerging markets go from running current account surpluses to running current account deficits to absorbing enormous amounts of capital.

That's the last point I want to make—that the collateral effects of these very innovative new policies were also large, that we know the repaired markets were unsure about how much to increase domestic activity. But we do know also that the spillover effects to other countries were in fact there, including through cross-border capital flows [and] cross-border banking flows. If you look at emerging market debt over this period, it takes off postcrisis as these policies are in place.

So then the last question—before I get to the political questions—is, what happens as these policies unwind? Of course, we've already seen one example of a very sharp unwind, which was the taper tantrum, which was a reaction to Chairman Bernanke hinting that in fact the QE would come to an end. Suddenly people brought back exactly the reverse of what they'd done earlier. They brought forward the expectation of interest rate increases, interest rates took off in the markets.

Now, over time, the Fed dialed that back down and convinced the markets that it was still going to be fairly accommodative for a fairly long time. The effects of the taper tantrum sort of dwindled. But it was a sharp wake-up call, that when the market reacts—when it thinks things are going to change—it can react very fast.

Since then, I think there has been a move toward soothing the markets and telling them anything that happens is not going to happen precipitously. I think that's the right sort of policy. Whatever we do, we have to do slowly and deliberately—not too slowly, for a reason I'll come to in a second—because the price effects that have been built up over time can reverse quite substantially if we do things fast.

For example, if balance sheets that have been built up over a long time are unwound, clearly when—I keep saying the Fed, but replace that with any central bank—when the central bank wants to unwind long-term assets that it has bought, or medium-term assets that it has bought, and essentially take back the reserves that it has issued to the banks, at first pass this is a simple swap. You're taking one set of assets that you hold and effectively giving it to the banks and saying, "You hold this. Give me back the reserves that you have." That itself shouldn't cause any problems.

However, remember that what the central bank has done is, essentially [it's] been playing the role of maturity transformer: issuing short-term, lending long-term. And it's getting out of the business, which means the private sector has to get into the business. So the private sector now will charge a premium for undertaking that role, which the central bank used to undertake without charging any fees for doing that. And therefore, you would expect that the appropriate price effects would show up, that typically—because the private sector now has to hold more long-term securities—essentially the price of those long-term securities will fall or interest rates will go up for the long-term assets. While the flipside—in the short term, it may become easier for the private sector to issue short-term securities because the Fed has gotten out of that business of issuing short-term securities.

Now, in a sense, these price effects will be there. If it's done in a measured way, it need not be abrupt. If, on the other hand, it is done pretty rapidly, then it could cause problems because the private sector essentially has to find space to absorb these kinds of assets, and that will be problematic.

Now, other effects that we would see—exchange rate appreciation in countries that are exiting this kind of accommodation. We would have, potentially, capital outflows from emerging markets. There are a number of studies now showing that as soon as monetary policy in the industrial countries tightens, the commercial banks that typically have lent short term try to bring their money back.

So these are all effects that we should see. It raises two questions: What, for example, should be the ultimate goal for the Fed—where should it be going? Should it be going toward, essentially, back to the pre-financial crisis balance sheet, or should it stop halfway? That's one question, and the second question is, where do we think risks will emerge that we haven't seen so far? So let me try and address these.

In terms of balance sheet, where should the Fed go? I think there are two changes that have happened, right? One is, of course, the assets that the Fed has built up, financed by issuing excess reserves to the banks, and paying interest on those reserves. To my mind, unwinding that or reversing that, to a large extent, is reasonable if it's done slowly over time. The idea is, if you unwind based on maturing securities, this can be done by 2022. I think that's reasonable.

Should it essentially take out all the excess reserves in the system? "All" means go down to about $100 billion—it's $2 trillion plus, at this point. And I would argue that, given that the Fed has a new way of setting the policy rate—which is allowing surplus excess reserves and paying interest on those reserves—it may make sense to allow that mechanism to continue. That mechanism is effective if you have a few more excess reserves—maybe $300 [billion], $400 [billion], $500 billion in excess reserves, rather than just $100 billion. So maybe don't unwind everything—go back to a moderate level.

But there's another argument that people make about the Fed's balance sheet—this is an argument that's made by [Fed Governor] Jeremy Stein—which is that the Fed moving into the business of maturity transformation was in fact a good thing, because the private sector should not be in that business as much as it was before the crisis. In other words, "funding short, lending long" is a source of risk, and the Fed moved into that business, de-risked the private sector, and perhaps the Fed balance sheet is the best to manage that risk. So what he would like is potentially the Fed balance sheet to stay large, while in fact it finances with excess reserves—so don't bring down excess reserves significantly from the current level.

I'm a little less convinced that the Fed should be in the business of maturity transformation. I think the private sector has to take it up. There are there virtues to doing it, for the private sector also, and [I'd] be happy to talk about that. I'm more sympathetic to going down to something like $400 [billion], $500 [billion] in excess reserves, rather than staying where you are or going back to zero.

Let me talk a minute about the political risks, and then [I'm] happy to take any questions, or just stop [laughs] as the case may be. One is that interest rates are going up, and the Fed doesn't have zero duration assets on its balance sheet. The assets have some duration. So as interest rates go up, what the Fed paid out in the past as dividends—because interest rates were coming down—will reverse, and the Fed will start making accounting losses on its portfolio.

Now, if you take the Fed's balance sheet and you take the government's balance sheet and put it together—well, essentially, one gains from lower interest rates over time. The other may, from higher interest rates or, over time, having issued at low interest rates in the past, and the other sort of loses—it should be a wash if you take the Fed and the government's balance sheet, consolidate it, and take it over time. But in the short run, it will look like the Fed—instead of paying $80 billion in dividends—is doing the reverse, sending $80 billion of losses onto the government balance sheet. And I presume it is accounted for in the budget, though somebody else...[conferring with an audience member] It's not. It's a separate item?

Nevertheless, the point is this: negative $80 billion is an accounting item, should be treated as such and ignored. But it is possible people may actually point a finger at the Fed and say, "You're making such big losses. Do you know how to manage your balance sheet? Do you know how to manage your business?" If I—a private sector banker that I once was, many years ago—made these losses, I would be fired. What about you?

It's not clear that these losses will be politicized, but they may be in the kind of environment that we have. That's one potential source of worry. Essentially, there are five members of the Fed Board up for reappointment, and hopefully they are reappointed in an apolitical way, but the Fed is potentially vulnerable.

A second place where central bankers have become more vulnerable—and I'll stop here—is, we could propagate the story that we were operating under instructions from the government, that all we had was freedom at the operational level, but we had a mandate which was given by the government. Now, as central banks have moved much more into these innovative policies, which are outside the norm of what central banks do, I think it has become easier to ask the question, "Yes, you have a mandate, but you seem to be able to do anything you want within that mandate. [laughter] You can buy cows, goats, horses. You can buy bonds, stocks, you can buy foreign exchange. There's no limit. So what is it that constrains your operational freedom?" And I think this is where, to some extent, central bankers—with these very innovative, very important, in some ways, policies—have injected themselves into the limelight—and also, therefore, raised the level of questioning.

Particularly problematic is if the central banker also is seen by the public as a hero—as, for example, Chairman Bernanke, or Mario Draghi in the euro area—as having done something extraordinary. Then you are directly competing with a politician for space that the politician likes to occupy and not have any competition. So my worry is that in this period when central banks have been the only game in town, in a sense they've also made themselves political targets. And I hope that as these policies unwind, they will become less sitting targets for the political establishment. And we'll stop there.


Audience member: Hi, thank you very much. You almost imply kind of a symmetry of ideas, that QE going in has the same effect of QE going out. But I wonder if, with the regulatory changes, banks going under—you know, putting so much more cash in the short end—that maybe that unwind is a bit more perverse, right? You end up pulling those cash out of reserves, and where they go? Do they really go into long-end Treasuries? Do they go into other securities? Do they actually come out of things like corporate credit and things like that and actually push, again, a bit of a different response? Because you could actually have a risk-off event, where basically you have money coming out of short end and actually going back into other securities—Treasuries and things like that—because it needs to come out of somewhere else. So it could be...

Rajan: Right. So there will have to be a rebalancing. At the very least, we should expect a reversal of the effects we saw when they came in, right? What you're saying is, we could see more. And we could see a magnification if, in fact, over and above it, there are expectational changes based on the reversal. What you're pointing out is, in this period we've also added regulations—more capital, etc., etc.—which may make it harder for banks to absorb riskier assets at the same old price—that in fact, they may have to be repriced a little differently. It's possible. That's why I'm saying, when we exit, [we'd] better do it in a stable way.

The only reason one can imagine that you maybe have to move faster is for political reasons. Even if, for example, inflation started spiking up, there's no reason for the central bank to increase the pace at which it reduces its balance sheet. It can pay higher interest rates on the reserves that are outstanding, if in fact it has to raise the policy rate. The only problem is, it will be making more losses on its assets, and that's where the political reaction comes in. If somebody says, "Oh, you lost $300 billion over the last year—isn't that a problem?" That's when it may, perhaps, be challenged to increase the pace of unwinding, which may create more turmoil. That's what I worry about. I hope it doesn't come to that.

Audience member: Thank you. I'd like to ask you about your thoughts about the impact of these policies on savers. I've been thinking a lot about Irving Fisher, the inherent nature of the origins of interest rates in time preferences. And the U.S. and much of the world is going through an incredible demographic shift, in terms of retiring population. So we think a lot about the attempts of unconventional policy to get interest rates, long-term interest rates, down and stimulate borrowing. But I'm curious on your thoughts about the impact of depressing interest rates, actually, for those who need to maintain a certain level of income in retirement, actually boosting their current savings. Maybe that policy is at a point where it has a perverse effect on stimulating demand. You can think of that in terms of the behavior of savers or in the behavior of pension funds, which try to match asset and liabilities. I'm kind of curious if you've thought of the impact of these policies on savers, and whether higher rates may actually be stimulative rather than repressive on the economy.

Rajan: Right. That's a very good question. It certainly is, I think, a plausible eventuality. People in Japan, people in Germany, say that is what is happening with the aging populations—they have an end-of-life savings goal. They usually invest in short-term, fixed-income securities. They don't really believe in the market, and so on—and now with interest rates really low, basically they have to save more to achieve that end-of-life savings goal.

That argument certainly can be made. Usually one would think that that aspect would be offset by the consuming population—the guys who take on debt being more willing to do that and consuming more. Of course, if those guys are highly levered and can't borrow any more, then effectively the perverse effect is the stronger effect. I actually wrote down a model on this, didn't do anything with it—you can get it in a reasonable model. The question is, is it a big effect? And I would say that, the longer we persist in a very low interest rate environment, the more these kinds of perverse effects start mattering.

Jim Bullard: Hi, Jim Bullard, [president of the] St. Louis Fed. You told a story about the effectiveness of QE—that it was a signaling effect. So while you're doing QE, obviously you weren't going to raise the short-term policy rate, and therefore this is maybe why it had some effects. It seems like that signaling effect wouldn't be there when you have a big balance sheet, so when you're reducing the size of the balance sheet there's no indication about what you may or may not do with the policy rate. So it seems like balance sheet reduction might be more benign than what you described in reaction to the first question that was asked from the floor here.

Rajan: Right, right. There would be an initial reaction, because if people think QE is going to fall over on QE—the so-called "QE infinity" view—when you say, "We are coming to an end," that would be the initial change in expectations, which could be abrupt and brutal. But once that's happened and they realize there's no more QE, then they know that things are going to proceed—and then that link can be cut. Absolutely right, absolutely.

Thank you very much.