End of emergency; not end of cycle

The fact that the sharp sell-off in global bonds over recent weeks was triggered by fairly innocuous comments by ECB President Draghi highlights the complacency that had set in about how long emergency monetary policy settings would be kept in place.

To better understand what is going on it is necessary to contrast a typical pre-crisis monetary cycle with the post-crisis cycle. Historically, the policy cycle has had three phases. In the first, policy rates were cut rapidly to stimulate an economy stuck in recession. The second began when self-sustaining growth kicked in and policy rates were increased ? not to slow the economy down, but to remove unnecessary accommodation. The cycle then reached its coda in the third phase, when economic and financial imbalances were growing and rates were raised with the intent to bring conditions back into equilibrium, but often went too far and pushed the economy into recession.

The post-crisis cycle has been more complex. Phase one rate cuts did not provide sufficient stimulus, so another extended emergency and unconventional loosening stage was necessary. That in turn has meant that the conventional rate increasing phases must be preceded by another in which emergency measures are withdrawn when no longer necessary. Significant shifts in the level and term structure of interest rates have tended to occur during the transitions between these emergency phases. We saw that during the ‘taper tantrum’ when yields rose sharply after Ben Bernanke began communicating that US QE tapering was coming (see Chart 1). We saw it in the months immediately after the ECB began its own QE programme. And we are seeing it again now that the ECB is implying that the days of its QE programme are numbered, and both the BoE and BoC are hinting that ultra-low interest rates are unlikely to last. But just as the Fed’s taper was not a signal that phase three of the policy cycle had begun, nor are these central banks doing that now. Instead they are simply saying that emergency policy settings are no longer necessary because economic and financial conditions are stronger and more resilient. The recent rise in rates should therefore be viewed as a sign that things are improving rather than a reason to fear that the cycle is coming to an end.

Jeremy Lawson – chief economist – Standard Life Investments