MNI INTERVIEW: CenBank Balance Sheets Key To Tariff Response

Central banks will have to respond to the U.S. trade policy shock via their balance sheets, with their earlier focus on using models to analyse the effects on trade flows and output having been rendered a sideshow by financial market disruption, the New York Fed’s former head of international studies Gianluca Benigno told MNI.

Risks of a U.S. recession have risen largely because of market turmoil rather than the real economy effect of uncertainty over trade, with echoes of previous financial shocks, Benigno said, though he expected a more targeted approach from the Fed this time around than "QE infinity".

"Interest rate policies as such can help, but they're not decisive in terms of addressing these dysfunctionalities that may arise in international financial markets and you need to use actively ... the balance sheet policy mix," he said an interview.

While enhanced liquidity operations may be preferred, "the Fed could, in principle, intervene directly, by deciding if the issue is dumping Treasuries or because of the basis trade.” (See MNI INTERVIEW: Fed Uneasy Over Optics Of Intervention-Kashyap)

The Fed has its standing repo facility as a first port of call, although this may need to be restructured to provide the liquidity required as the Treasury market comes under strain.

"I think they will probably use a more targeted approach as opposed to quantitative easing ... currently the repo facility is not [working] completely smoothly. They might try to amend it, or they might try to step into the market in a way that essentially tries to guarantee the liquidity of Treasuries,” he said. (See MNI: Fed Should Create Backstop For Basis Trade Unwind - Paper)  

While the Treasury selloff at the beginning of the week seemed to reflect mainly liquidity issues, in later sessions it has taken on characteristics of a broader loss of confidence in U.S. assets, Benigno said.

The Chinese central bank has already indicated support for purchases of exchange-traded funds by sovereign wealth fund Central Huijin and the Bank of England has warned of a higher likelihood of severe financial shocks, as it expands its range of liquidity tools.

TRADE MODELS SIDELINED

Initial analysis published by central banks in the wake of Donald Trump's election victory focused on trade models in assessing the potential hit to growth and uncertain inflationary effects of both tariffs and rising measures of trade uncertainty, but, Benigno said, "the trade shock ...becomes secondary to the financial dimension. The financial dimension precedes the real trade shock."

"All these measures of trade uncertainty ... basically look at how many times certain keywords are mentioned in selected newspapers and so on. But if you go and look at the credit spread, for example, since Trump's election, uncertainty spikes, but the credit spread has been very flat up to very recently," he said.

"Those indices capture something, of course, but I don't think that they are a good signal in terms of thinking of what might come ahead.”

Having previously downplayed the risk of recession in the U.S., as its relatively closed economy is more likely to be able to withstand a trade hit with offsetting fiscal stimulus, Benigno said the financial shock has increased the likelihood of a downturn.

"I was never worried about trade uncertainty, until I see that this trade uncertainty is associated with credit spreads widening. That's where you see the danger of volatility ... when spreads open up and because then you get emotion in markets, truly the macro financial shock," he said.