The global economy is in the midst of an unprecedented macroeconomic policy experiment based on unconventional monetary policy marked by a combination of high public debt, near-zero interest rates and aggressive quantitative easing.
As a recent IMF policy assessment pointed out, the initial deployment of those policies appears to have been quite successful in restoring market functioning and reducing tail risks. There may also have been some benefits for growth and price stability, although here the Fund admits that the evidence is rather less clear cut.
The same paper goes to caution that the growing scale of central bank activities brings with it some significant risks. In particular, there are huge uncertainties around both the medium- and long-run implications of the current period of historically low policy interest rates, and around the mechanisms for, and consequences of, exit strategies from these extreme policy settings.
In the first chapter of its April 2013 World Economic Outlook, the IMF issued another reminder of the medium-term dangers associated with the developed world's monetary policy experiment. The Funds worry list included the possibility of ultra-low interest rates encouraging excessive risk-taking, balance sheet mismatches, high leverage, and asset price bubbles. In addition, asset price collapses, sovereign debt stress, banking sector crises, large destabilising global capital flows and exchange rate movements are all possible outcomes should the exit from the current experiment go pear-shaped.
The last couple of weeks have given us a taste of how some of this could play out. Back in late May, when Ben Bernanke gave markets a signal that the Fed might consider slowing the pace of its current US$85 billion-a-month program of asset purchases, the following days brought a spike in US bond yields and the worst monthly loss for bond investors since December 2010. And yesterday saw emerging market assets undergo a sharp sell-off, once again sparked in part by the prospect of changes in Fed policy.
Markets' current obsession with the potential timing and scale of the Fed 'tapering' its asset purchases are a reminder of some of the big uncertainties surrounding the economic outlook. There's no doubt that the monetary experimentation of the past few years has been warranted by the nature of the crisis confronting policymakers (although failure to deliver adequately on other fronts has probably placed excessive pressure on the monetary authorities to accommodate shortcomings elsewhere). But we still don't know what the fallout of all that experimentation will be.
The global economy's rollercoaster ride looks far from over.