Bank of England Deputy Governor Charles Bean in his valedictory speech says that the exit from exceptional monetary stimulus will not be easy.
Bean cites the problems the US Federal Reserve has had over its tapering of asset purchases, the “taper tantrum”, and sets out why the BOE is likely to face a tough time unwinding its stg375 billion of asset purchases and getting Bank Rate back up from its record low 0.5%.
“I do not expect central banks’ collective management of the exit from from the present exceptionally stimulatory monetary stance will be easy,” Bean says.
“The bumpiness of the incoming data, allied to a state-contingent reaction function, means that market interest rates are bound to become more volatile along the exit path, however well central banks communicate their intentions,” he says.
With implied volatilities in many financial markets at historically low levels Bean says this has encouraged a search for yield which is “eerily reminiscent of what happened in the run-up to the crisis.”
He warns there may be an underestimation of risk by investors and at some stage market perceptions of uncertainty will revert to more normal levels.
“The bottom line is that we may yet encounter a few potholes on the way to the exit,” Bean says.
He says the BOE is unlikely to start gilt sales until Bank Rate is high enough that it could be cut to support demand if things deteriorated, and gilt sales are likely to put upward pressure on yields.
On the upside, the regulatory push has helped ensure banks are better capitalised and leverage is lower.
Bean, in his London School of Economics lecture, draws on the lessons of his career as a policymaker.
He defends forward guidance, saying there is persuasive evidence business has understood the central message, that rate hikes are not imminent and should be gradual and limited, and has raised investment in response.
Bean argues quantitative easing is best used in dysfunctional markets when Bank Rate is near the zero bound.
While the first round of QE, launched at the height of the financial crisis, worked Bean says the signs are that the second round of QE has had limited impact.
“There are good reasons to believe the impact (of the second round of QE) was smaller because the markets were less dysfunctional than after the collapse of Lehman’s,” Bean says.
On current BOE policy Bean restates the guidance and thinking set out in May Quarterly Inflation Report.
He notes the BOE puts spare capacity at 1 to 1.5% but says there is a “considerable degree of uncertainty around this estimate.”
He also notes this estimate of spare capacity is only a short-run concept, and that the BOE will aim to close it over two to three years.
The crisis highlights the need to develop macro-prudential policies alongside monetary policy, and Bean looks at the complexities of dove-tailing the two. At times, he believes the two will be facing in opposite directions.
For example, loosening monetary policy in response to a positive supply side shock could boost investors’ risk taking, which may require tighter macro-prudential policies.
Bean, the current Deputy Governor, Monetary Policy, is retiring from the Bank on June 30, with MPC member Ben Broadbent taking over his role.