What happens when the taps turn off?

The aftermath of the global financial crisis has been marked by two trends in economics. First, central banks have embarked on the aggressive printing of money. Second, some politicians and investors have misunderstood the financial market implications of those policy decisions.

Central banks did not print money on a whim. Central banks printed cash because people, companies and banks wanted to hold cash, and they wanted to hold a lot more cash than had traditionally been the case.

Let's take the US Federal Reserve as the example. From 2007 until the end of 2012, the Fed printed a huge amount of money. In fact, the Fed printed a little more than US$2 trillion. That took the Fed's balance sheet to 18.5% of GDP at the end of 2012 - negligible compared to the levels in Japan, Switzerland or even the euro area, but still a trebling of the ratio.

But the question, of course, is where that money went. We can see this fairly readily. Companies' cash holdings rose by almost $250 billion over the period. Households' cash holdings rose by $637 billion. Money under the metaphorical mattress took down 43% of the Fed's printing. This was not money out pursuing equities, commodities, or international markets. This was money gathering dust - in economic terms, this cash was dead.

What about the rest of the money? Well, time deposits also rose for companies and consumers. Corporate time deposits absorbed $124 billion of liquidity. Household time deposits absorbed $1.33 trillion of liquidity. Add those numbers up and cash and deposits held by US companies and households rose by more than the amount the Fed printed (this is possible because of what economists call the money multiplier effect).

The Federal Reserve was simply slaking an insatiable thirst for liquidity. These results can be replicated for other central banks, and it tells us something very important. There is really no direct evidence that the money printed by the Fed (or others) went into financial markets. That would be consistent with the fact that the volume of transactions in financial markets have not risen dramatically as central banks have printed money.

This is not to deny the indirect ways in which printing money has influenced risk markets. Setting the printing presses rolling has had two consequences. The first of these is that government bond yields are very low. Technically central banks buy less-liquid assets (government bonds) in exchange for cash. Central bank purchases of government bonds have driven down their yields. That causes investors to change behaviour - if they cannot get the yield that they need from government bonds, they will look to buy other asset classes with higher yields.

The second consequence of central bank action is reduced risk. When quantitative policy first occurred, the world economy faced a major liquidity crisis.

Investors and companies would do almost anything to get cash (regardless the economic consequences). By reassuring everyone that cash was available, central banks reduced risk which obviously helps support riskier assets. It should be no surprise that financial markets reacted most strongly to the first round of quantitative policy measures (when there was the biggest reduction in risk).

Why is all this important? It is important as the US starts to debate ending quantitative policy. If quantitative policy had flooded the world's markets with money, then turning of the liquidity tap would have a very direct and negative impact on global financial markets. However, this is not what happened, and there is no reason to suppose that ending quantitative policy will have a direct impact on global financial markets.

If central banks are reducing their purchase of government bonds it seems fair to suggest that bond yields will rise. That will have an impact on other markets, and change investment decisions - although it is worth noting in passing that a central bank is only likely to end quantitative policy if economic data, and by extension government deficits, are improving.

The risk environment is not likely to be negatively affected by central banks reducing liquidity. Central banks are run by sensible economists. They will not reduce liquidity unless they are sure the economy is strong enough. In other words, the economic climate is likely to be supportive for risk assets, whenever the central bank reduces its support.

What this means is that investors should not automatically assume that when the Fed turns off the liquidity tap there will be an automatic correction in all risk markets. Investors should judge markets on their own merits, and not get misled by stories of "floods" of liquidity flowing from central banks to financial markets. Those stories are demonstrably untrue.


Paul Donovan is deputy head of global economics for UBS Investment Bank in London.

About the author

columnist
Writer: Paul Donovan
Position: Deputy Head for Global Economics at UBS Investment