Normalization of Monetary Policy
On September 20, in a Federal Open Market Committee meeting that is held eight times a year, the US Federal Reserve decided not to change its Fed funds rates or prime rates, which currently sit at around 1 to 1.25 percent.
The Fed also decided to jumpstart a program to reduce its securities portfolio in its October balance sheet. Since the global financial crisis of 2008, the Fed’s balance sheet has skyrocketed to US$4.5 trillion, four times the amount before the crisis occurred. What does the action mean and what are its implications for developing economies, such as Indonesia?
The swelling of the Fed’s balance sheet
In implementing its double duty of ensuring monetary stability and boosting economic growth, the Fed faced the heavy challenge of the 2008 global financial crisis followed by the great recession. As we all know, the global financial crisis was triggered by the subprime mortgage loan crisis in the US’ housing sector that later spread everywhere after the Lehman Brothers megabank was neglected to bankruptcy in September 2008.
As a monetary guardian, apart from rescuing banks and financial institutions facing liquidity difficulties in the time of crisis, the Fed also made efforts to boost the economy after the recession hit the US economy. This second aspect usually falls under the government’s authority through fiscal stimulus.
However, due to political disagreements between the Republican and Democratic Parties regarding the amount of budget and fiscal stimulus deficit and fears of the skyrocketing of both, it was difficult to realize any policy. Fiscal stimulus was only provided at the beginning of the recession when the US government used its budget to help the financial and real sectors, including the automotive industry, through its troubled asset relief program (TARP) in late 2008. Through the G-20, the US also pushes other countries to take the same action. Indonesia was among the countries that implemented such a policy at the time.
In facing such a reality, the Fed implemented a monetary policy that in my opinion replaced a fiscal policy that was stunted by political gridlock. The Fed implemented a very loose monetary policy through the decrease of prime rates down to near zero, known as the near-zero rate-of-interest (NZIRP) policy and zero interest rate policy (ZIRP). Other developed countries, including Japan and those in Europe, even implemented a negative interest rate policy (NIRP).
Apart from that, the Fed also implemented a program on the massive buying of securities, both treasury securities and mortgage-based securities (MBS) – which are financial institutions’ securities based on bills of mortgage loans. These two moves that have been implemented since 2008, namely the low interest rates and the buying of securities, are known as unconventional monetary policies.
They are unconventional as terribly low and near-zero, or even negative, interest rates are not common in finances. The purchase of MBS means that, basically, the Fed is giving loans to housing and property businesses, which is not the central bank’s responsibility. The central bank only provides loans for other banks in its function as lender of last resort (LOLR).
The goal had been to decrease long-term interest to encourage people to invest due to the low banking credit. There are similar aims with the buying of securities, as this will push interest rates down. This policy had prevented the US economy from falling into a depression like in the 1930s. The unemployment level, which reached 10 percent in 2008/2009, was recently only 4.4 percent. Meanwhile, the inflation growth remained below the target of around two percent.
Regarding a central bank’s liquidity assistance for banks in Indonesia, many are of the opinion that the provision of the Bank Indonesia Liquidity Support (BLBI) during the 1997/1998 banking crisis was a mistake. Surely people have the right to make opinions. However, Bank Indonesia decided to make the move as part of its responsibility as LOLR to save the banking and payment systems, not to save bankers and bank owners, let alone to save certain groups of bankers. The policy was implemented indiscriminately to all banks that experienced bank runs due to the crisis. The buying of securities by the Fed during the global financial crisis and the great recession for years was basically the same as the BLBI provision to rescue banks during the 1997/1998 banking crisis.
Return to conventional monetary policy
As the US economy has shown signs of returning to stability in the last two years – evident in the sustainable low growth and full employment – the Fed wishes to change its monetary policies from unconventional to conventional.
The prime rate interest as reference for daily interbank loans has increased since December 2015. In 2017, it has been increased by a quarter percent twice to the current level with a plan to increase it once more at the end of the year.
What about the quantitative easing (QE) program? The implication of a loose monetary policy in the form of buying of securities, also known as QE, is that the Fed holds an increasingly large amount of securities in its balance sheet. For around eight years of implementing QE, the securities held by the Fed have accumulated from below US$1 trillion before the crisis to US$4.5 trillion recently. The return to normal monetary policy is achieved by reducing the amount of securities in the Fed’s balance sheet (read “Observing the Streamlining of the Fed’s Balance Sheet”, Soedradjad Djiwandono, Kompas, 14/6/2017).
Until now, each time the Fed received money from matured securities, it always reinvested the money in new securities and there was not liquidity withdrawal in the economy. However, starting in October, the Fed will stamp matured securities, starting from US$10 billion, and gradually increase it until it reaches US$50 billion in order to decrease the amount of securities.
Until now, it has yet to be clear what the normal amount of securities is. However, all governors are of the opinion that the new level will be much higher than before the crisis, perhaps around US$2 trillion or US$3 trillion. If this is correct, there will be between US$1.5 trillion and US$2.5 trillion of maturing securities. This is the amount of securities that will be reabsorbed by the amount currently in circulation.
Be aware of changes
Both the increase of interest rates and liquidity withdrawal through the streamlining of the Fed’s balance sheet will eventually affect global finances. Until now, the increase of the Fed’s prime rate has always been done gradually and not followed by the central banks of other developed countries. However, the recent economic improvements in Europe and Japan will surely make the European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ) move away from their loose economic policy, including the NIRP and the purchasing of securities like what the Fed did.
When the Fed increased its prime rate in March, there were concerns that it would significantly affect developing countries in Asia due to capital outflow from these countries to the US, much like the 2013 taper tantrum. However, this did not occur. In my opinion, this is because the prime rate increase was done only by the Fed (read “Saved by the Bell”, Soedradjad Djiwandono, The Jakarta Post, April 2017).
If my prediction is correct that the Fed’s streamlining of its balance sheet would be followed by similar moves by the ECB and perhaps also BoE and BoJ, then developing countries must be prepared to face shrinking liquidity that will trigger capital outflow from developing countries, including Indonesia, to the US and other advanced countries.
It is true that the financial conditions of developing countries, including Indonesia, are much more solid nowadays compared to the past – with good capitalization of banks, healthy exposures and fund sources for banks, proper management of the exchange rate system and a safe amount of foreign exchange reserves – therefore preventing another taper tantrum like in 2013.
However, this does not mean that we can be complacent, let alone careless. Staying alert in the spirit of eclecticism – including preparing ourselves, staying flexible and nimble and being ready to respond to changes – must always be the posture of our monetary policy and of economic agents in the face of risks and uncertainty.
Bank Indonesia has just dropped its reference interest rate by a quarter of a percent after doing the same just last month. I believe this move gives us a better latitude if, later on, we need to restrict our monetary position as we face capital outflow influenced by advanced countries’ moves to leave behind their nonconventional monetary policies and return to normal ones.
Professor Emeritus of Economy, University of Indonesia; Professor of International Economy, RSIS, Nanyang Technological University (NTU) Singapore.