BRUSSELS/FRANKFURT (Reuters) - The impact of the U.S. central bank unwinding its policy stimulus risks being greater now than in 1994, when it started a tightening cycle and bond markets crashed, a European Central Bank policymaker said on Tuesday.
ECB Executive Board member Joerg Asmussen said the 1994 episode highlighted the importance of central banks clearly communicating exit strategies from their expansionary policies.
The U.S. Federal Reserve is expected to start slowly reducing its bond purchases when it meets later this month, beginning to unwind a policy that has helped foster recovery in the world’s largest economy and buoyed financial markets.
“In early 1994, when the U.S. recovery gained strength, the Fed started a tightening cycle and bond markets crashed not only in the U.S. but also around the world,” ECB Executive Board member Joerg Asmussen said on Tuesday.
“If spillovers were large in 1994, we can expect them to be even larger today in an even more deeply interconnected world,” he added in the text of a speech for delivery in Brussels.
The Fed began a sharp tightening cycle in 1994 with large rises in the Fed funds target rate that pushed long-term rates higher across the globe. The spillover was blamed by many for triggering Mexico’s so-called Tequila crisis in 1994 and 1995.
While economists believe the Fed could still announce a tapering of its monthly bond purchases at its September 17-18 policy meeting, they believe weak jobs growth data has increased chances of a delay.
Even if the Fed were to decide later this month to begin reducing its stimulus it would still have a highly expansionary monetary policy with interest rates nailed down near zero.
But RBS economist Richard Barwell said the timing of the exit was tricky for all major central banks.
“They are right to worry that if and when any of the major central banks start to move (to the exit) it won’t be an orderly transition,” he said in response to Asmussen’s comments. “There’s no easy way.”
Abandoning its tradition of never pre-committing on future moves, the ECB said in July it would keep its rates at current or lower levels for an “extended period” - its first use of forward guidance.
The ECB repeated the ‘extended period’ line after both its August and September meetings.
ECB President Mario Draghi, when pressed at his August 1 news conference on how markets would know when the guidance had ceased, said simply that investors had “all the parameters” to judge when the language on forward guidance might be changed.
“They don’t want the market to get addicted to their guidance,” said Barwell.
Two lessons could be drawn from the 1994 episode, Asmussen said: firstly, clarity on central banks’ “reaction functions” - how they respond to shifts in economic data - is crucial.
“Is it clear what the ECB’s reaction function is? That’s where I think they need to do more with their communication,” said Barwell, pointing to ambiguity around the inflation forecasts ECB policymakers look at and their influence on policy.
“How far below 2 percent does the inflation forecast have to be before it is a problem too big to ignore?” he asked.
The second lesson from the 1994 experience was that inflation expectations must be well-anchored, Asmussen said.
“Inflation fears amplify the impact of economic developments on yields,” he said, adding that while exit strategies were being debated in some economies, “for us in the euro area it is too early to start the exit.”
The ECB could take further easing measures: “The ECB remains ready to act if conditions deteriorate,” Asmussen said.
His comments echoed the ECB’s position after its policy meeting last week, when the bank said it was ready to cut interest rates or pump more money into the economy if needed to bring down money-market rates and help the euro zone’s recovery.
Asmussen repeated his support for the idea of the ECB joining other major central banks in publishing minutes of its policy meetings - a possibility under discussion at the bank.
“In my personal view the minutes, summarizing the main policy discussions, should include who voted for what, and the reasoning behind that vote,” Asmussen said, playing down the risk of pressure being put on national central bank chiefs.
“In my view someone who takes up such a position should be able to withstand such pressure.”
Editing by Hugh Lawson/Ruth Pitchford