Prospects for and Ramifications of the Great Central Banking Unwind

At the CFA Institute Global Investment Risk Symposium held in Washington, DC, on 7–8 March 2013, William Poole gave a presentation on what he calls the “great central banking unwind.” Total assets on the balance sheets of the U.S. Federal Reserve and European Central Bank have exploded since 2008. The challenges and pressure faced by these and other central banks will probably have serious consequences for the global economy.As the U.S. Federal Reserve System and European Central Bank (ECB) have struggled to deal with the aftermath of the 2008 global financial crisis, total assets on these banks’ balance sheets have exploded. The Fed’s expansionary monetary policy has been motivated primarily by a concern over unemployment; the ECB’s policy has been motivated by an effort to support the sovereign debt of fiscally weak governments. Because of concern over slow employment growth, the uncertainty of economic forecasts, and political pressure—among other things—the Fed has been slow to address the issue of its buildup of assets. Although it may appear that the Fed has to unwind its position, the Fed, in fact, has the option to hold its portfolio indefinitely. It can do so by raising the interest rate it pays on bank reserves as required to prevent an explosion of money and bank credit growth.The ECB has acquired a substantial amount of the sovereign debt of the fiscally weak southern European countries and has been lending to banks that have purchased the debt of those countries. The ECB will not be able to unwind its position until Spain, Italy, Portugal, and Greece resolve their fiscal problems. I believe the fundamental fiscal weakness in Europe will end in a crisis.Because the monetary policies since the crisis are unprecedented, there is no standard for what to do now. So far, inflationary pressures remain subdued, but the ability and willingness of the Fed and the ECB to react quickly to control inflation fears are in jeopardy, largely because of political forces.