Exit/Enter QE?

If the theoretical discussion in the context of monetary policy, through most of 2009, has been centered on the different tools disposable to central banks in the form of unconvetional measures it seems almost certain that 2010 will be all about putting theory into action. Most notably is of course the much debated concept of exit strategies from quantitative easing (or enhanced credit support in the case of the ECB), what it means to really exit, how to exit, and when to exit.

Starting with the last point the G3 central banks have pretty all indicated that the latter part of 2009 and beginning of 2010 would see a gradual, but firm exit from quantitative easing and thus, essentially, unwinding of asset purchases and extraordinary liquidity provisions. In terms of how and without going too much into details all three central banks have clearly communicated how they intend to unwind QE if and when they see it fit. Finally, and on the first point it is naturally much more difficult since you can really only answer this question ex-post.

As I argued recently communicating an exit strategy may be quite simple not least since this task appeals to the more technocratic discourse which central banks master with ease, but actually performing one in practice may not be so easy. Recent evidence seem to vindicate this point.

Consider then the 12-month loans from the European Central Bank set to end with the last allotment the 15th of December where the ECB, according to Bloomberg, will lend as much as 150 billion euros ($227 billion). Now, the fact that demand for this tender will large is not so important but that it comes at this point in time when markets and the economy seem decidedly fragile is quite another;

(quote Bloomberg)

The ECB, which may detail conditions for the loans tomorrow, will lend banks 150 billion euros ($227 billion) in the Dec. 15 tender, according to the median of 19 economists in a Bloomberg News survey. That’s double the 75.2 billion euros banks drew in September, though less than half the 442 billion euros allotted in the first tender in June. The ECB will offer the loans at a fixed 1 percent, its current benchmark rate, 18 of the economists said.

The ECB has already signaled this month’s 12-month loans are likely to be the last as it starts to scale back its emergency lending to banks. With financial markets jittery after Dubai last week said it would seek to delay debt repayments, and Greece’s ballooning budget deficit pushing up its borrowing costs, European banks may take the opportunity to stock up on the ECB’s cheap cash.

“Take-up could potentially be very large, it’s the last opportunity to get into what could be a nice little earner,” said James Nixon, co-chief European economist at Societe Generale SA in London, who expects demand to total 200 billion euros. “Given the wobbles about Greece and Dubai, the ECB will cross their fingers and hope the 12-month tender goes off without too much of a problem.”

Clearly, today's ECB meeting will tell us a lot, not least in relation to whether the ECB will be offering this final tender at a fixed rate or, in foresight of excess demand, deploy a variable rate. As Societe Generale points out in their latest ECB watch, Trichet and co seem very eager to remove liquidity as soon as possible as they consider the risk that banks' operations may become too dependent on them. Naturally, I agree with this position, but as ever the ECB risks facing some hard questions in the context of e.g. a double dip recession in Germany, a blowout in Spain or Greece (which is coming), or if suddenly an event akin to the Dubai unravelling enters the stage to disrupt markets. Especially on the second point, it will be very interesting to see how intra-Eurozone spreads react to the unwinding of bank funding as I have long suspected (as well as many others) that the liquidity provided by the ECB has been used to fund the widening fiscal deficits in the Eurozone.

Elsewhere in the G3 or more specifically, at the BOJ any talk of an exit from QE was temporarily halted this week as the BOJ held an emergency meeting where the central bank responded to the increasing woes of the government by committing to a 10 trillion yen ($115 billion) program to supply loans to commercial banks at the prevailing refinancing rate of 0.1%.

(quote Bloomberg)

The central bank yesterday said it will offer three-month loans to commercial banks at 0.1 percent under the new facility. Governor Masaaki Shirakawa stopped short of boosting the monthly target for government-bond purchases from 1.8 trillion yen, a step analysts said may be taken within months.

The decision followed escalating warnings from Prime Minister Yukio Hatoyama’s government about the danger of prolonged consumer-price declines, exacerbated by the surge in the yen to a 14-year high. By contrast, Shirakawa, who met with Hatoyama today, in recent weeks raised his economic assessment and announced plans to end some emergency lending programs.

Shirakawa’s announcement “aimed to explicitly show the BOJ’s stance to cope with deflation and strong yen pressures proactively with minimum action,” said Junko Nishioka, chief economist at RBS Securities Japan Ltd. in Tokyo, who previously worked at the Bank of Japan. “We look for the bank to be eventually pushed into taking further actions to satisfy the government.”

As is readily clear, the decision by the BOJ to re-enter, as it were, QE follows mounting worries in the government about an annual deflation rate of some 2% and a JPY trading close to 80 to the USD which is not fun when you are dependent on exports (not to mention that Japan has also lost competitiveness to its main Asian rivals). It is of course particularly interesting to note the idea of the BOJ "satisfying" the government which seems a farcry from the situation in Europe where Trichet couldn't give a sh'te about the cries from Eurozone government leaders. In this way, we should not be surprised to see the BOJ announcing that it is about to step up the purchase of government bonds. Gleen Macquire from Societe Generale (who is very good on Japan mind you) estimates, according to Bloomberg, that monthly government-debt purchases need to exceed 2.2 trillion to 2.5 trillion yen to have a "meaningful effect.

Of Theory and Practice

The two examples above show that while exit strategies may be very nice and handy in theory, they are bit more difficult to initiate in practice. In this respect, it is important for me to emphasize that I am no QE apologist who simple believes that liquidity provisions should be provided indefinitely and without a critical view of the underlying circumstances. However, at this point in time the central banks may be playing a dangerous game, especially in the case of the ECB where I would expect it to be a bit more difficult to simply turn on the tab again if it turns out that the initial decision to exit was premature. In this sense, it is the strenght as well as the weakness of the ECB that it tends to climb onto a very high horse in relation to regime changes and major policy reversals (although to be fair, the ECB has repeatedly stated that it is not committed either way).

In any case, I will be following the QE exit stragies played out before us in real time with some interest since they are bound to provide important precedence for future policy makers.