Risks building up with increasing monetary stimulus

Investors are counting on central banks to provide more monetary stimulus to keep markets afloat. However, despite an extension of Operation Twist last week, another round of quantitative easing from the Federal Reserve may not come soon.

Bloomberg reported the view of St Louis Fed Bank President James Bullard on this matter on Friday:

Federal Reserve Bank of St. Louis President James Bullard said today a possible third round of quantitative easing would face a “pretty high hurdle.”

“We can do that and I think it would be effective,” Bullard said in a television interview on Bloomberg Surveillance with Tom Keene. “But we’d be taking a lot more risk on our balance sheet. We’d be going further into uncharted territory.”

The European Central Bank has also been unwilling to do much more to help ease the region's debt crisis, preferring to put the onus on political leaders to solve the crisis.

Such views seem consistent with that of the Bank for International Settlements, based on the latter's latest annual report published on Sunday. Excerpts from Chapter I of the report:

Over the past year, central banks in the advanced economies have continued or even expanded their purchases of government bonds and their support of liquidity in the banking system...

The extraordinary persistence of loose monetary policy is largely the result of insufficient action by governments in addressing structural problems...

With nominal interest rates staying as low as they can go and central bank balance sheets continuing to expand, risks are surely building up. To a large extent they are the risks of unintended consequences, and they must be anticipated and managed. These consequences could include the wasteful support of effectively insolvent borrowers and banks – a phenomenon that haunted Japan in the 1990s – and artificially inflated asset prices that generate risks to financial stability down the road. One message of the crisis was that central banks could do much to avert a collapse. An even more important lesson is that underlying structural problems must be corrected during the recovery or we risk creating conditions that will lead rapidly to the next crisis.

In addition, central banks face the risk that, once the time comes to tighten monetary policy, the sheer size and scale of their unconventional measures will prevent a timely exit from monetary stimulus, thereby jeopardising price stability. The result would be a decisive loss of central bank credibility and possibly even independence.

Having said that, last week's economic data mostly showed that the global economy is still weakening. Flash purchasing managers' indices in the United States, China and the euro area all showed either slower growth or contraction in June.

Therefore, more doses of monetary stimulus in the near future by central banks certainly cannot be ruled out.