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Tony Crescenzi, Ben Emons, Andrew Bosomworth, Isaac Meng
Saddled with debt and mindful of recalcitrant investors, nations in the developed world have lost their ability to solve their economic woes by adding more debt, leading them more than ever to rely upon central bank action. It is fantasy, however, to think that central banks can keep the game going for long. No central bank ever created anything tangible – you won’t find any stories about a Fed chairman discovering electricity or creating the light bulb. What central banks are best at creating is fiat currencies, and these are only as valuable as what they are backed by, whether it be gold, silver or the productive capability of a nation. Create or print too many of these and they will have no value to anyone, save for nerdy numismatists.
All that a central banker can do to add value to society is help foster financial conditions that facilitate the efficient use of capital, but even here central bankers can get it wrong and produce exactly the opposite result. The housing bubbles that preceded the onset of the recent financial crisis are proof; they were in fact at the heart of the crisis.
Central bankers today are striving valiantly to help smooth the deleveraging process by promoting conditions aimed at reflating the value of financial and real assets that would otherwise almost certainly fall in price. This isn’t easy to do because the world is striving just as valiantly to reduce its debt, taking actions that result in persistent downward pressure on asset values.
Central bank liquidity can’t turn the lights on in Italy
The orderly liquidation of debt requires economic growth. By boosting asset prices, central bankers have sought to promote economic growth and buy time for the fiscal authorities of the developed world to formulate and implement growth-oriented policies. Global investors have been patient, but the repeated failure of policymakers has their patience running thin.
No amount of central bank liquidity by the Federal Reserve, the European Central Bank (ECB) or any other central bank can possibly fix what ails the developed economies. The ECB, for example, can’t fix the fact that Italy ranks 109th out of 183 countries in providing electricity. Nor can it fix the fact that Spain ranks 133rd in the ease of opening a business. How about Greece?
Can the ECB reduce the size of government, improve tax collection or reduce the number of occupations Greece considers so hazardous that hairdressers, pastry chefs and clarinet players can retire in their early 50s? In the U.S., can the Fed reduce the outsized growth rate of the entitlement system? Central bankers can do nothing about these competitiveness issues, but the restoration of growth and competitiveness is essential to improving the ability to repay debt.
To use football vernacular – and here I mean American-style football – central bankers have taken the ball about as far down the gridiron as they can. To be sure, they can still do more; the Fed could implement another round of asset purchases, cap Treasury rates, cut the interest rate it pays banks on excess reserves, extend further its conditional promise to keep rates low, or perhaps consider some form of credit easing. If the Fed did any of these it would mark another courageous effort by The Decider, Fed Chairman Ben Bernanke, but it will never get the ball into the end zone.
To cross the goal line, to restore growth and competitiveness, the fiscal authority – not the monetary authority – must move the ball. This isn’t easy because the citizens of the world are voicing their objection to the changes necessary to do so. Try all you might, central banker, but at the 99th yard you will find the longest yard!
Unlimited global monetary policy – Ben Emons
In recent media debates, some commentators have pointed out that quantitative easing (QE) programs may have seen their effectiveness diminish. However, monetary policymakers in both developed and emerging markets continue to pursue easing measures. Different kinds of policies emerged, such as the Bank of England’s direct lending scheme, known as “credit easing.” The European Central Bank and the Danish central bank went another direction, cutting their deposit rates to zero or even negative. The lower zero bound is often viewed as a constraint, a limit in using conventional tools. The ECB and Danish central bank decisions to cut deposit rates showed how conventional policy is not necessarily limited. In fact, all central banks could cut deposit rates or rates on excess reserves in order to “force” out large cash balances held at the central bank to stimulate lending.
There could be “practical limits,” where QE or deposit rate cuts cause nominal and real interest rates to turn negative, affecting future income streams on savings accounts, pension funds and money market portfolios. The central banks’ growing market share in longer-term Treasury bonds and their low yields has added to the challenge. These practical limits are not necessarily seen as a barrier, evident by the recent string of actions by emerging and developed market central banks. Milton Friedman argued in his 1968 paper, “The Role of Monetary Policy,” how monetary policy should be based on limits. His view was that policy should not “peg” interest rates for a prolonged period of time or it may lead to structural inflation. Friedman pointed out that rapid monetary base growth was generally associated with high nominal rates, a sign in his view of easy policy, e.g., Brazil in the 1960s. Low interest rates were related to slow money growth, like the U.S. during the 1930s, which Friedman viewed as tighter monetary policy. Friedman saw the setting of rates connected to the amount of money growth the central bank would conduct to influence price expectations. When interest rates are pegged in an environment of seemingly stable inflation expectations, Friedman noted a risk of disconnect where the monetary base could become uncontrollable and lead to higher inflation.
In today’s environment of low interest rates, monetary base growth and stable inflation expectations, such disconnect is not seen as a risk, as debt deleveraging has been overwhelming. Since most major central banks see deflation as a bigger risk at this point, practical limits or those limits that Friedman spoke of do not seem to be tempering the willingness of global central banks to go further. In fact, as the global slowdown materializes further, we can expect more policy tools will be deployed to stem the pace of deleveraging, and without any limits.
The ECB can only provide a bridge – Andrew Bosomworth
The ECB can only provide a bridge for the European monetary union’s problems, not a solution. Its decision to cut all policy rates by 25 basis points (bps) earlier this month signaled the bank’s ongoing willingness to provide that bridge by creating time for political and fiscal agents to implement durable solutions. Judging by the gyrations in yields on southern European bonds since the ECB’s meeting, however, markets were evidently disappointed the ECB did not announce further unconventional measures to shore up Europe’s dysfunctional bond markets. Even after ECB president Mario Draghi’s “whatever it takes” statement on 26 July, we still have not seen yields on outer peripherals drop to sustainable levels.
Market expectations for unconventional measures derive from at least two sources. First, since the ECB crossed the Rubicon in 2010 by buying Greek government bonds, markets now believe the bank will do whatever it possibly can to prevent the Economic and Monetary Union (EMU) from breaking up; the costs of not doing so would be too great. Indeed, the ECB currently holds €211 billion in securities from previous forays into the bond market. Second, some market participants, policymakers and influential figures, like Italy’s prime minister and the head of the IMF, are lobbying the ECB to buy even more in order to drive southern European bond yields lower.
Such proposals are shortsighted and address the symptoms rather than cause of the EMU’s problem. Buying bonds without fixing the design faults in the EMU’s governance structure is a near-term fix whose beneficial effects, like painkillers, will soon wear off. Were the ECB to follow lobbyists’ calls and resume the Securities Market Program (under which it bought government debt in 2010 and 2011), it will not solve the governance structure problem. However, buying bonds to ward off deflation once conventional monetary policy has reached the zero lower bound is likely warranted.
The ECB usually refers to Article 123 of the Treaty on the Functioning of the European Union, which prohibits it from financing governments’ budget deficits. The ECB’s reasoning is not entirely clear, given the same European law (part of the Lisbon Treaty) governs both the ECB and Bank of England (BoE) yet the latter buys government bonds as part of its quantitative easing. We think the explanation lies in differences between the ECB and BoE’s perceived risk of deflation, the degree of trust between the monetary and fiscal authorities and the fragmentation of the EMU government bond market relative to the singularity of the United Kingdom’s government bond market owing to its centralized fiscal policy.
As credit to the EMU’s private sector declines – the natural consequence of deleveraging after a credit boom – the risk of deflation in Europe is likely to rise. We think deflationary forces will intensify, making a further reduction in the main refinancing rate to 0.5% likely and perhaps necessitating quantitative easing. Which government bonds might the ECB buy in those circumstances?
The ECB’s capital key (which reflects each member country’s proportional contribution to total capital) suggests about one-quarter and the largest allocation of purchases would be in German Bunds. But capital flight to Bunds has already driven their yields abnormally low, suggesting quantitative easing would achieve little. And the ECB would send mixed signals if it concentrated purchases in Italian and Spanish government bonds. Would the ECB do this to offset eurozone-wide deflation risks or to compensate for member states’ reluctance to centralize fiscal policy?
Purchasing the bonds of the European Stability Mechanism (ESM) could circumvent this dilemma. Unlike the ECB, the ESM is designed to provide member states with financial assistance subject to conditionality. While it lacks the same degree of democratic legitimacy as Europe’s parliaments, at least the ESM is a child born of the democracy. However, like its predecessor, the European Financial Stability Facility (EFSF), the ESM’s main weakness is that it is unfunded. We think the ESM will find it equally difficult to raise sufficient funds from the capital market at low enough yields to perform the job it is designed for. And even if it finds buyers, the ESM will likely crowd out demand for other government bonds from Italy, Belgium, France and Austria, thereby raising their borrowing costs. Quantitative easing using ESM bonds could thus prove to be yet another bridge that buys politicians more time but does not solve the root problem. When it comes to Europe there is only one thing we can say with certainty: This crisis is not yet over.
People’s Bank of China moves to counter weakening growth – Isaac Meng
Policymakers in China face different limitations today than those in the U.S. and Europe, but they too have had to respond to the strain in the global economy, especially as slowing global demand exerts downward pressure on China’s export-investment-driven growth model. In a surprise move, the People’s Bank of China (PBOC) cut its benchmark rate by 25 bps twice within a month. The PBOC also deregulated deposit rates, allowing a 10% float above the benchmark, which largely offsets the cut’s effect on deposit and lending rates.
Though one to two months earlier than the market expected, the latest rate cut is not surprising in light of weakening growth and a slowing inflation outlook. Second quarter growth at 7.6% is barely above target, and inflation risk is easing fast with CPI likely stay below 2.5% over the next two to three quarters versus the PBOC’s target of 4%. Even though rates were cut by 50 bps, China’s real rates are still rising because CPI is heading down toward 2%. If the PBOC targets positive real deposit rates as a floor in the medium term, then there is still room to cut another 25 bps to 50 bps. The 8% to 9% average lending rates remain too high for borrowers struggling to deleverage amid a deepening industrial slowdown.
With the Chinese yuan’s outlook and foreign flows turning to a more balanced stance, the PBOC needs to further unwind past foreign exchange sterilizations, most likely by cutting the Reserve Requirement Ratio by 50 bps per quarter to maintain money market rates in the range of 2.5%–3.0%.
Despite room for monetary easing, the PBOC still seems behind the curve in easing financial conditions. Chinese banks remain tight in credit and slow to cut their lending rates. Domestic Chinese borrowers have excess capacity to deleverage, and the yuan’s nominal effective exchange rate is rising amid a rigid foreign exchange rate regime. Thus, we expect real economic growth in China to be muted and slow, and while some stabilization is possible in late 2012, it is hard to see a sustained recovery.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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