Taper talk a prelude to bigger policy debate - Capital Economics
Global Economics

Taper talk a prelude to bigger policy debate

Global Central Bank Watch
Written by Global Economics Team

Talk of tapering in recent weeks has been premature and we suspect that most major central banks will keep up asset purchases at their current pace for the rest of the year. Assuming that tapering starts once recoveries are well underway, and that the process is well communicated, we do not foresee a repeat of the “taper tantrum” of 2013. With that being said, the sheer scale of the expansion in central banks’ balance sheets over the past year will have major implications of the conduct of monetary policy in the post-pandemic era – and is likely to require further unconventional thinking by policymakers.

  • Taper talk is premature and purchases typically won’t slow until next year
  • There is absolutely no rush for central banks to shrink their balance sheets
  • But when they do, the process will require some creative thinking

Talk of tapering in recent weeks has been premature and we suspect that most major central banks will keep up asset purchases at their current pace for the rest of the year. Assuming that tapering starts once recoveries are well underway, and that the process is well communicated, we do not foresee a repeat of the “taper tantrum” of 2013. With that being said, the sheer scale of the expansion in central banks’ balance sheets over the past year will have major implications of the conduct of monetary policy in the post-pandemic era – and is likely to require further unconventional thinking by policymakers.

Taper talk is premature

The prospect of further fiscal stimulus and some hawkish remarks from Atlanta Fed President Raphael Bostic and Dallas Fed President Robert Kaplan prompted speculation in January that the US Federal Reserve might start to slow the pace of its asset purchases before long. At the same time, ECB President Christine Lagarde seemed less concerned by the rise in Italian bond yields than markets might have hoped and indicated that the Bank might not need to use the entire €1.85trn “envelope” of its recently enlarged Pandemic Emergency Purchase Programme. All of this prompted a significant rise in yields in the US and the euro-zone.

But Fed Chair Jerome Powell has since made great efforts to dampen such speculation, stating after the Fed’s recent policy meeting that it was far too early to be talking about withdrawing support when the Fed has only just pledged to keep its asset purchases at the current pace until “substantial further progress” has been made towards achieving its employment and inflation goals. Those dovish comments support our view that, even though fiscal policy and vaccination are likely to boost economic growth this year, the Fed will only begin to taper its asset purchases early next year. As for the ECB, its forecast for core inflation to be only 1.2% in 2023 is a long way short of its target. And with the outlook deteriorating in recent weeks, we think that January’s upside surprise will prove to be a one-off. Since sovereign bond yields remain the most important measure of financing conditions in the euro-zone, it would make no sense for the Bank to let spreads widen. The existing PEPP envelope allows for bond purchases to continue at their recent pace until mid-2022 and we suspect that in fact purchases will go on until at least the end of that year.

Elsewhere, the Bank of England’s current tranche of QE allows for purchases to go on until the end of 2021, albeit probably at slower pace in the second half of the year. Meanwhile, the Reserve Bank of Australia seems likely to announce one last $100bn round of QE at its June meeting, allowing purchases to continue until the end of the year. The Bank of Japan is now buying very little, but this reflects market conditions rather than a desire to reduce policy support and the Bank is committed to keeping 10-year yields near 0%.

Central banks have learned the lessons of 2013

But the key point is that a repeat of the 2013 “taper tantrum” when the Fed’s announcement of a future slowdown in the pace of asset purchases prompted a surge in yields seems unlikely. Concerns about the potential inflationary and financial stability risks of quantitative easing have eased since those early days and banks will be more comfortable to continue buying until recoveries are well underway. A key lesson of 2013 was that careful communication is essential and any plans to consider an exit strategy are likely to be set out well in advance. What’s more, when tapering is announced, it seems unlikely that markets will interpret this as a precursor to interest rate hikes as they did back then. Policymakers have made it clear that they have learned the lessons of tightening too soon after the Global Financial Crisis and some have already declared their intention to keep interest rates on hold for a few years to come.

Policymaking in the post-pandemic era

The discussion over tapering is one aspect of a more fundamental debate that is starting to develop around the conduct of monetary policy following the pandemic. A key aspect of this relates to how central banks manage their super-sized balance sheets. 

Chart 1: Central Bank Balance Sheets (% of GDP)

Source: Refinitiv, Capital Economics

Over the past year, the size of the Fed’s balance sheet has increased by $3.2trn (16% of GDP), the ECB’s balance sheet has increased by €2.4trn (20% of GDP) and the Bank of England’s balance sheet has grown by £323bn (16% of GDP). (See Chart 1) This expansion of balance sheets was the right response given the circumstances and helped to prevent an even deeper economic crisis. But attention is starting to shift to the problems that huge central bank balance sheets might create in the future. 

In practice, many of these have been overstated. For example, the expansion of central bank balance sheets will not automatically lead to a rise in inflation further down the line. We’ll have more to say about all of this in a forthcoming Global Economics Focus. However, there are several ways in which the huge size of central banks’ balance sheets – and the asset purchases that sit behind them – might complicate the conduct of monetary policy in future. In particular, it could add to the pressure on central banks to keep interest rates extremely low. 

The need to keep interest rates low in order to keep the public debt burden from spiralling out of control has been well documented. But steps taken during the pandemic mean that a rise in interest rates would also put the balance sheets of central banks under pressure. There are two aspects to this. The first relates to interest payments paid and received by the central bank – since the assets it has bought (typically government bonds) pay a fixed coupon, but the reserves it created to buy them pay a variable interest rate, any increase in rates will have an adverse effect on the net income of central banks. At the same time, a rise in interest rates would typically push down the price of the bonds held by the central bank – thus reducing the value of its assets and potentially causing it to operate with negative equity. 

None of these problems materialise if interest rates stay low. They only start to crystalise if inflation picks up in a major way, such that central banks need to tighten policy. If this were to happen, their super-sized balance sheets could force them to take increasingly creative steps to choke off demand without forcing up the interest rates it pays on reserves or yields on government bonds. This is less of a problem for the Fed, since the ratio of its assets to commercial bank reserves is much larger than in other countries (reflecting the US’s exorbitant privilege of being the world’s reserve currency and thus the greater volume of dollars in circulation). But it’s not inconceivable that it could become an issue for the Bank of England, where the ratio of assets to bank reserves is lower.

Even then, there are ways to overcome the problem. For example, one way to do it would be to implement reserve requirements for commercial banks, pay zero interest on these required reserves (thus reducing the interest bill incurred by central banks) and then force commercial banks to hold more government debt (thus limiting the rise in yields relative to other interest rates). But it would represent an effective tax on commercial banks, with all the obvious consequences for lending to the private sector. It would also constitute a form of financial repression

To be clear, none of this is bound to happen and it is certainly not on the immediate horizon. Inflation is unlikely to become a problem in major advanced economies in the next few years and the focus should remain on keeping policy support in place until the post-pandemic recovery is entrenched. But we should expect these ideas to enter mainstream discussion over the coming years. The global financial crisis and then the pandemic forced central banks into adopting increasingly unorthodox policies. Managing the legacy will require similarly creative thinking. 

Monetary Policy Developments

Review of recent policy rate changes

The global rate cutting cycle appeared to run its course at the end of last year – since November, there have been no rate cuts in any of the 20 major economies covered in this report, with most central banks keeping policy rates unchanged. (See Chart 2.)

There was one key exception to this and that was in Turkey. Indeed, with the CBRT keen to re-establish its inflation-fighting credentials, policymakers increased the key policy rate by 475bps in November and by a further 200bps in December to 17%, due to stronger than expected inflation.

Chart 2: Changes in Benchmark Rates

Source: Bloomberg, Capital Economics

Rates on hold in DMs, but more change in EMs

While we expect most central banks to keep interest rates on hold this year, there are several exceptions, particularly in the emerging world. (See Table 1.) A handful of EM economies – including India, Russia, Mexico, and Poland – will continue to loosen policy this year. In India, while financial markets and analysts appear convinced that policy rates will be left on hold this month, we think that the recent drop in headline inflation could be enough to trigger a 25bp rate cut. Meanwhile, it’s a similar story in Russia – while investors are anticipating tightening, we still think that there is scope for one more 25bp cut to 4% later this year. And in Mexico we expect one further 25p cut as well, as Banxico gradually shifts towards tolerating higher inflation.

Table 1: Summary of CE Forecasts for Policy Rate
Net Changes by the End of 2021

Policy Direction

Economies

Easing

Denmark, India, Russia, Mexico, Poland.

No Change

US, UK, Euro-zone, Japan, Canada, Australia, Switzerland, Norway, Sweden, South Korea, Turkey, Poland, South Africa.

Tightening

China, Brazil.

Source: Capital Economics

In contrast, China and Brazil look set to go it alone and begin to tighten monetary policy in 2021. In China, tighter policy will be reflective of the rapid rebound in economic activity. Indeed, with output well above trend and underlying inflation starting to recover, the People’s Bank has already reversed much of its policy easing of last year. We expect policymakers to extend this tightening with 30bps worth of hikes this year.

Meanwhile, in Brazil, rate hikes are less about a strong economic recovery and instead a reflection of high inflation and concerns about the direction of fiscal policy. But we doubt that policymakers will deliver the aggressive tightening cycle that most currently anticipate.

In DMs, we expect rates to remain on hold in most economies. Denmark is the key exception where continued upward pressure on the currency peg, means that we expect the Nationalbank to cut interest rates from -0.6% to -0.75% in Q2.

There has been plenty of speculation that the Bank of England could cut interest rates from +0.1% now into negative territory. Indeed, markets expect that interest rates will be cut to below zero in the first half of this year. But we do not think that the BoE will be able to say that it is operationally ready to implement negative interest rates at this month’s meeting. And by the time it is prepared, we doubt that such a move will be necessary as the economy will already be rebounding.

DM asset purchases to continue this year

As previously discussed, central banks in most DMs will continue their asset purchases at a steady pace in 2021. (See Chart 3.)

Chart 3: Monthly Asset Purchases ($bn)

Sources: Refinitiv, Capital Economics

In the US, despite our expectations that the economic rebound will be strong and in contrast to markets’ expectations, we think that the Fed will maintain asset purchases at around $120bn per month. And when the Fed does begin tapering in 2022, we think that it will reduce asset purchases at a very gradual pace and will ultimately continue to buy a modest amount of Treasury securities each month.

In the UK, the Bank of England (BoE) has only completed around £16bn of the £150bn it announced in November – so there is still a lot more policy support in the pipeline. At its current pace of purchases of around £4.4bn a month, this tranche of QE is set to come to an end in September. It is possible that the Bank could speed up the pace of purchases. But comments from the MPC suggest that the BoE would only do this to ease illiquidity, rather than as a way of boosting inflation.

Meanwhile in the euro-zone, if asset purchases continue at their present pace, the current PEPP envelope of €1.85trn is likely to run its course by mid-2022. But we think that the ECB will eventually extend its net asset purchases under the PEPP again, perhaps until the end of 2022.

Table 2: Central Bank Policy Rates

Country

Policy rate

Latest

Last Change

Next Change

(CE Forecast)

End-2020

End-2021

End-2022

Major Advanced Economies

US

Fed funds target

0.00-0.25

Down 150bp (Mar. 2020)

None on horizon

0.00-0.25

0.00-0.25

0.00-0.25

Euro-zone

Deposit rate

-0.50

Down 10bp (Sep. 2019)

None on horizon

-0.50

-0.50

-0.50

Japan

Interest on excess reserves

-0.10

Down 10bp (Jan. 2016)

None on horizon

-0.10

-0.10

-0.10

UK

Bank Rate

0.10

Down 65bp (Mar. 2020)

None on horizon

0.10

0.10

0.10

Other Advanced Economies

Canada

Overnight target rate

0.25

Down 50bp (Mar. 2020)

None on horizon

0.25

0.25

0.25

Australia

Cash rate

0.10

Down 15bp (Nov. 2020)

None on horizon

0.10

0.10

0.10

Switzerland

Sight deposit rate

-0.75

Down 50bp (Jan. 2015)

None on horizon

-0.75

-0.75

-0.75

Sweden

Repo rate

0.00

Up 25bp (Dec. 2019)

None on horizon

0.00

0.00

0.00

Denmark

Deposit rate

-0.60

Up 15bp (Mar. 2020)

Down 15bp (Q2 2021)

-0.60

-0.75

-0.75

Norway

Sight deposit rate

0.00

Down 25bp (Apr. 2020)

None on horizon

0.00

0.00

0.00

New Zealand

Cash rate

0.25

Down 75bp (Mar. 2020)

None on horizon

0.25

0.25

0.50

Major Emerging Economies

China

7-day reverse repo rate

2.20

Down 20bp (Mar. 2020)

Up 10bp (Q1 2021)

2.20

2.50

2.50

India

Repo rate

4.00

Down 75bp (Mar. 2020)

Down 25bp (Q1 2021)

4.00

3.50

3.50

Brazil

Selic rate

2.00

Down 25bp (Aug. 2020)

Up 25bp (H2 2021)

2.00

2.50

3.00

Russia

1-week repo rate

4.25

Down 25bp (Jul. 2020)

Down 25bp (Q3 2021)

4.25

4.00

4.00

Mexico

Overnight target rate

4.25

Down 25bp (Sep. 2020)

Down 25bp (Feb. 2021)

4.25

4.00

4.00

South Korea

Base rate

0.50

Down 25bp (May 2020)

None on horizon

0.50

0.50

0.50

Turkey

1-week repo rate

17.00

Up 200bp (Dec. 2020)

Down 50bp (H1 2022)

17.00

17.00

14.50

Poland

Reference rate

0.10

Down 40bp (May. 2020)

Down 10bp (Mar. 21)

0.44

0.00

0.00

South Africa

Repo rate

3.50

Down 25bp (Jul. 2020)

None on horizon

3.50

3.50

3.50

Sources: Bloomberg, Capital Economics.

Table 3: Quantitative Easing & Other Unconventional Policies

Central bank

Planned Asset Purchases & Lending Facilities

CE Forecast of Future Changes

Federal Reserve Bank

The Fed has pledged to continue large-scale asset purchases at least at the current pace – equating to about $120bn per month. The majority of the Fed’s emergency lending facilities came to an end at the end of 2020, but specific elements were extended until March 2021.

We do not expect the Fed to do anything more than it has announced this year. We anticipate that the Fed will taper its asset purchases gradually in 2022 and will ultimately continue to purchase a modest amount of treasuries each month.

European Central Bank

The Pandemic Emergency Purchase Programme (PEPP) envelope of asset purchases was increased to a total €1.85trn in December 2020. New Targeted Longer-Term Refinancing Operations (TLTROs) were announced in December.

We suspect that policymakers will want to extend the PEPP perhaps until the end of 2022 (note at the current pace and with the current envelope, net asset purchases will be exhausted by mid-2022.)

Bank of Japan

Modest asset purchases set to continue where necessary to defend yield target. The results of its “assessment for further effective sustainable monetary easing” will be revealed at the March 2021 meeting.  

We expect the Bank to slow the expansion of its balance sheet as economic activity continues to recover. The Bank will probably widen the tolerance band around its 0% target for 10-year yields, perhaps to ±30bp, at its March meeting.

Bank of England

By the 27th January, the Bank of England had used only £16bn of the £150bn QE tranche. At the current pace of purchases, this tranche of QE will be completed in September.

We do not anticipate that the Bank of England will need to expand QE or use negative interest rates in 2021 or 2022.

Bank of Canada

The Bank of Canada recently announced that it would maintain the pace of its government debt purchases at $4bn per week. The Bank signalled that we should expect a reduction in the pace of purchases this year although the programme will continue for a “long time yet”.

We suspect that the Bank will wait until September to start tapering its purchases and will ultimately continue them in some form into 2022.

The Reserve Bank of Australia

The Reserve Bank of Australia extended its Bond Purchase Program by $100bn to end-August at its February meeting. And by noting that even in its upside scenario inflation would remain below the lower end of its target band in future, it signalled that more easing will be needed.

We have pencilled in a third extension to $300bn at the Bank’s June meeting, with the weekly pace remaining at $5bn and the split between federal and state bonds unchanged at 80%/20%.

Swiss National Bank

The SNB continued to describe the franc as “highly valued” and reiterated that it is willing to intervene in the FX market as necessary despite being branded a “currency manipulator” by the US Treasury.

We think that the SNB will be able to dial back its FX interventions this year. But this is because we think that upward pressure on the Swiss franc will ease as risk sentiment improves, not because of the US Treasury’s actions.

The Reserve Bank of New Zealand

The Reserve Bank of New Zealand has pledged to buy $100bn in government bonds by mid-2022 but it has slowed its purchases in recent months and is on track to undershoot that target.

We expect the Bank to slow its asset purchases further and to end them altogether by the middle of this year as the economic recovery keeps surprising to the upside.

Riksbank

The Riksbank increased the size of its asset purchase programme by SEK 200bn to SEK 700bn at its November meeting, extended the duration of the programme by six months until the end of 2021 and broadened the range of assets that it would buy.

As it stands, the Riksbank plans to use around 60% of the new envelope by the end of Q1 this year. We think it is more likely than not that the ceiling will be raised again in the April meeting.

Sources: Central banks, Capital Economics.

Table 4: Calendar of Policy Decisions

Date

Economy

Policy Instrument

Prior

Survey

CE Forecast

4th February

United Kingdom

Bank Rate

0.10

0.10

5th February

India

Reverse repo rate

4.00

3.75

9th February

Sweden

Deposit rate

0.00

0.00

11th February

Mexico

Overnight lending rate

4.25

4.00

12th February

Russia

1-week repo rate

4.25

4.25

18th February

Turkey

7-day repo rate

17.00

17.00

20th February

China

7-day repo rate

2.20

2.20

24th February

New Zealand

Cash rate

0.25

0.25

25th February

South Korea

Base rate

0.50

0.50

2nd March

Australia

Cash rate

0.10

0.10

3rd March

Poland

Reference rate

0.10

0.00

10th March

Canada

Overnight target rate

0.25

0.25

11th March

Euro-zone

Deposit rate

-0.50

-0.50

17th March

US

Fed funds target

0.00-0.25

0.00-0.25

18th March

Norway

Sight deposit rate

0.00

0.00

18th March

United Kingdom

Bank Rate

18th March

Turkey

1-week repo rate

19th March

Japan

Interest on excess reserves

-0.10

-0.10

19th March

Russia

1-week repo rate

22nd March

China

7-day repo rate

25th March

Switzerland

Sight deposit rate

-0.75

-0.75

25th March

South Africa

Repo rate

3.50

3.50

25th March

Mexico

Overnight lending rate

6th April

Australia

Cash rate

7th April

Poland

Reference rate

14th April

New Zealand

Cash rate

15th April

South Korea

Base rate

15th April

Turkey

1-week repo rate

20th April

China

7-day repo rate

21st April

Canada

Overnight target rate

22nd April

Euro-zone

Deposit rate

23rd April

Russia

1-week repo rate

26th April

Sweden

Deposit rate

27th April

Japan

Interest on excess reserves

Sources: Bloomberg, Capital Economics


Neil Shearing, Group Chief Economist, neil.shearing@capitaleconomics.com
Jennifer McKeown, Head of Global Economic Service, jennifer.mckeown@capitaleconomics.com
Gabriella Dickens, Global Economist, gabriella.dickens@capitaleconomics.com