The current period can be described as “unusually uncertain,” the phrase that Federal Reserve Chairman Ben Bernanke chose to describe the economic outlook in July 2010 in his semi-annual monetary policy report to Congress. There are indeed a plethora of uncertainties, most of which relate to the deleveraging process occurring in the debt-laden developed world and the negative influence it is having on the global economy and the financial markets. These uncertainties and the ravaging effects of deleveraging are what prompted the Fed and other central banks to take decisive action early on in the financial crisis, to both stop the rot and spur new growth.
Today, the Federal Reserve itself faces an “unusually uncertain” period because it lacks a complete understanding of the potential side effects of its unconventional policy actions; in particular the elongated timeline of its zero interest rate policy and its massive money printing – more specifically, the creation of bank reserves, the monies that banks utilize to make loans. These reserves entered the banking system through the Fed’s large-scale asset purchase programs (LSAP), or QE. In total, since early 2009 the Fed purchased $1.75 trillion in Treasury, agency, and mortgage-backed securities, money that helped to reflate the value of financial assets, promote economic growth, and prevent deflation in the prices of goods and services, a very important condition to avoid during a period of deleveraging.
Uncertainty over the potential side effects of the Fed’s unconventional policy actions were highlighted recently by New York Fed President William Dudley, a “core” member of the Federal Open Market Committee (FOMC) and one of the “big three” (consisting also of Fed Chairman Ben Bernanke and Fed Vice Chair Janet Yellen) believed to have the most sway in formulating the Fed’s monetary policies. On 12 April Dudley said that it’s “not free to do another round of quantitative easing,” adding that the Fed might “reconsider” additional stimulus if the U.S. economy faltered, implying that further stimulus was not imminent.
A day prior to Dudley’s comments, Fed Vice Chair Janet Yellen said that “considerable uncertainty” surrounds the economic outlook, and she spelled out conditions by which she would adjust her views toward either further policy easing or an earlier than expected policy tightening. Yellen’s unspoken point was that she is against further easing at the present time.
Minutes to the FOMC’s 13 March meeting show that support for additional easing was low at the time, with only “a couple of members” favoring further easing, saying their support was conditional and dependent on either a loss of economic momentum or if inflation seemed likely to move below the Fed’s 2% inflation target.
Support for QE in March was low ostensibly because of recent developments that relate to the Fed’s dual mandate. I noted in my last Global Central Bank Focus titled, “To QE or Not to QE,” that the key reason the decision to implement QE would be delayed was largely because of progress made on the two sides of the Fed’s dual mandate: employment and inflation; data on both fronts have given the Fed reason for pause.
Progress on both sides of the dual mandate, combined with the considerable uncertainties over the potential side effects of QE as well as the economic situation more generally make it is easy to see why Dudley and Yellen, two of the most ardent supporters of past QEs, are not yet on board for another round.
Uncertainty is a risk that cannot be measured
The unusual uncertainty that the Fed itself now faces complicates its ability to weigh the potential costs and risks of further policy actions against the potential benefits because the uncertainty is a risk that cannot be measured. Economist Frank Knight in 1921 sought to distinguish between risk and uncertainty when he penned his famous book titled “Risk, Uncertainty, and Profit,” noting their measurability is what distinguished them:
“Uncertainty must be taken in a sense radically distinct from the familiar notion of risk, from which it has never been properly separated. The essential fact is that “risk” means in some cases a quantity susceptible of measurement.”
To illustrate, consider the liabilities that insurance companies face for car accidents. Owing to actuarial analyses and the like, the liabilities are actually measurable uncertainties that by Knight’s definition are not uncertainties at all – they are measurable risks. An uncertainty that cannot be measured is a true form of risk.
Watchful waiting in pursuit of opportunistic reflation
Until recently, the longest stretch over the past 50 years that the federal funds rate – the policy rate set by the Federal Reserve – was kept unchanged or virtually unchanged was from January 1996 through September 1998, when the funds rate was either 5.25% or 5.50%. Minutes to the December 1996 FOMC meeting show the Fed describing that period as one of “watchful waiting.” It is a phrase that can hardly be assigned to the period since December 2008, even though the federal funds rate hasn’t been changed since then, when the Fed lowered it to its current range between 0% and 0.25%. Since then, activism has best defined the Fed, with the Fed easing policy through QEs and by other means.
There nonetheless are two important connections between the current period and the “watchful waiting” period of 1996–1998. For one, the Fed in 1996 was uncertain about the non-accelerating rate of unemployment (NAIRU). In other words, the Fed was unsure of the connection between economic growth, employment and inflation. Today the Fed faces a similar question, with inflation running higher than current estimates of NAIRU would suggest they should. (Read Janet Yellen’s 11 April speech for a thorough discussion of this). This makes the Fed somewhat more hesitant to ease policy in the absence of weaker growth or a decrease in the inflation rate.
Second, the “watchful waiting” period of 1996–1998 was the result of a strategy pursued by the Fed known as “opportunistic disinflation,” a phrase coined by Federal Reserve Governor Larry Meyer to describe the Fed’s strategy of holding monetary policy steady to maintain a condition in which the economy is expanding and inflation is at a subdued level that can be tolerated for several years or more. As Meyer explains,
“[The opportunistic approach] takes advantage of inevitable recessions and positive supply shocks to ratchet down inflation over time. Proponents of this strategy sometimes describe this approach as reducing inflation cycle to cycle or describe the economy as being one recession from price stability.”
In a similar vein, today it can be said that the Fed is pursuing a strategy of “opportunistic reflation,” which is to say that the Fed is engaged in a strategy of reflating asset prices, with the goal of maintaining the status quo, whereby asset prices are reflated as a means of aiding the deleveraging process. In other words, this means investors should expect the Fed to continue pursuing a strategy in which interest rates are kept below the rate of growth in nominal GDP, in order to help debtors – including the U.S. government – liquidate, or reduce their debts relative to income. Activism is the best means to accomplish this, but it can also work in a period of “watchful waiting,” so long as the Fed keeps its policy rate low and indicates it will likely keep it low for a long time.
The stage of global reflation
— Ben Emons
Since the financial crisis there have been four distinct stages in global central bank policy. Each period of activism included sequential responses by central banks focusing on liquidity injections to support asset prices. In Figure 1 each period is briefly described: Central banks have now arrived at the stage of “reflation.” The term reflation refers to a policy-induced recovery of the price level back to its longer term trend or target. It is a policy that has duality in terms of proactive and reactive signals to financial markets to influence growth and inflation expectations.
And sequentially until 2011, central banks were successful in achieving some objectives of price stability until the crisis in Europe accelerated. This led to further creativity in deploying tools and now policies are becoming explicitly aimed at higher inflation for a period of time. Reflation can result in inflation exceeding a target significantly, driven by factors such as a narrowing output gap, debt reduction or currency devaluation. It is central to how inflation expectations are formed, whereas rational expectations say inflation can suddenly change if a policy shift takes place.
The policy shifts have happened quickly since 2007 and that has led to intertwined unconventional policies. The reason for this is that deleveraging, structural unemployment and output gap conditions are similar across major developed economies. As displayed in Figure 2, below, with the average output gap negative and gross debt-to-GDP a large overhang, more reflation policy is to be expected via further increases of global liquidity and continuing negative real policy rates. The intertwined aspect is not without consequences however. Concerns about excessive currency strength as a result of these reflation policies have been expressed by other central banks in the emerging and developed world either verbally or in the form of direct foreign exchange interventions.
At the same time, such currency strength may lead to further declines in inflation (Brazil, Mexico), below target inflation (Norway, Sweden) or even deflation (Switzerland) which encourages reflation policies on the part of these countries' central banks that have a ”beggar thy neighbor” character. The result is a race to the bottom where each central bank is looking to weaken their currency by using targeted policies such as market intervention to keep their currencies from appreciating too drastically.
Financial markets have consequently become more reliant on monetary policy than before, engendering expectations that become unhinged yielding to further dislocations. These dislocations affect economic reality and, as seen in Figure 2, the wedge between the output gap and debt-to-GDP can remain wide. This width may entice central banks in some developed economies to perform further rounds of liquidity injections until a maximum amount of liquidity is reached, likely when and if there is a preemptive tightening or high inflation. Pursuing this maximum liquidity essentially pushes the tradeoff between addressing high economic leverage as measured by debt-to-GDP and potentially developing structurally higher inflation expectations down the road. For the time being, major central banks are putting off this tradeoff for the benefit of jumpstarting their economies, setting the stage for reflation that is characterized by currency fluctuations, excess liquidity and monetary repression.
Back to basics
— Andrew Bosomworth
How does one explain the almost four percentage point gap between yields on 10-year Spanish and U.K. government bonds? Spain’s unemployment rate has risen to depression levels reflecting the bust after its property market boom. There is uncertainty about contingent liabilities that might materialize on the central government’s balance sheet from Spain’s fragile savings banks and autonomous regions. But the U.K. isn’t that much better. Its property cycle was equally impressive and a similar look at contingent liabilities is not flattering for the British sovereign. Perhaps the yield gap has more to do with the two countries’ different governance structures. For starters, the United Kingdom is a fiscal union. Markets need not worry about economic differences between Wales and Scotland (yet), because fiscal transfers flow across regional borders. Then there is the Bank of England (BOE). It has an explicit indemnity from H.M. Treasury against potential losses on its balance sheet arising from purchases of U.K. Gilts. Simply put, the BOE can print enough sterling to ensure the U.K. government can repay its debt whereas Banco de España cannot print euro to ensure its government’s solvency. Spain trades as if it had borrowed in foreign currency.
When central banks monetize debt in the extreme it is unequivocally inflationary. The Reichsbank proved that in 1923. But what matters in shaping market expectations about inflation and deflation are the credibility of fiscal policy, the prospect for real economic growth and the central bank’s commitment to step back from the punch bowl. Markets have no doubt the European Central Bank (ECB) will do the latter. But they see depression in Spain rather than the growth needed to service its debt and so they punish fiscal austerity there while rewarding a more mediocre austerity effort in the U.K. It’s the policy combination that matters. Reducing the budget deficit and growth enhancing structural reforms, the conventional policy prescription for Spain, are necessary for regaining the market’s confidence. But without a monetary policy as supportive as the BOE’s they exacerbate a negative spiral whereby austerity reduces economic growth requiring even more austerity to meet the missed fiscal target. Alternative policy prescriptions, such as exiting the euro or running an expansionary fiscal policy in Germany, fail to take into account legal constraints, political commitment to euro membership or the precarious nature of Germany’s own public finances. Europe’s unfunded rescue vehicles don’t have the credibility to support Spain, let alone Italy. Under the current governance structure, it seems the only way a country can survive in the euro area is by self-insuring itself via moving to an internal and external surplus. Financial autarky, or national self-sufficiency, has its costs though. Highly indebted sovereigns and corporations with little prospect of growth may default in the process.
Like the BOE, the ECB has the power to ensure its sovereigns remain solvent. Without structural reforms that enhance growth, however, and without changes to the euro’s fiscal governance structure that ensure taxation only with democratic representation, bond purchases may prove to be just another short-term bridge to nowhere. What would help investors, and perhaps the ECB to act more boldly, is the fiscal equivalent of the Delors Report, i.e., a credible, long-term commitment to a common fiscal policy: the Euro T-bill Fund, with a “joint and several” guarantee from all participating eurozone states, as proposed by Hellwig and Philippon, or a debt redemption fund as proposed by the German Council of Economic Experts, could be stepping stones along the way. Perhaps the only way to overcome voters’ political resistance to complementing monetary with fiscal union is to allow systemic stress to become even more severe. PIMCO hopes the destination is a stronger and more federal Europe rather than a return to legacy currencies. We are prepared for a bumpy journey ahead just in case.
The calm before the storm?
— Lupin Rahman
Like backseat passengers in a joyriding car, emerging market central banks have been hostage to the turmoil in developed markets. Not only have emerging markets (EM) experienced the economic fallout from lower global trade and declining external demand, they have also borne the fallout from the policy reactions (and inactions) of their developed-world counterparts. With the shift in global sentiment in the first quarter of this year, the ride now appears less precarious than before. In particular, the ECB’s LTRO has clipped the global left-tail risk outcome and greatly reduced the probability of a European banking crisis in the short-term. Meanwhile the Fed’s more neutral tone has diminished market expectations of QE3 and the accompanying flood of hot money capital flows to EM.
Macroeconomic indicators have also shifted, offering EM central banks greater room to maneuver. Growth expectations across emerging markets have come down following disappointing Q4 2011 numbers as well as indications of a stronger-than-expected slowdown in China and Europe. Consensus now expects the largest emerging markets (including China) to grow 6.3% on average, lower than the 7% in 2011 but still higher than PIMCO’s forecast of 5.5%. Meanwhile declining momentum in headline CPI and declines in near-term inflation expectations have alleviated inflationary pressures across several emerging markets.
So is it clear sailing from here or is this merely the calm before the storm?
Several factors point to the latter.
First, the crisis in Europe is far from resolved with renewed concerns about Spain as well as the policy reaction of the ECB to rising Spanish government yields. These all point to the economic reality that the European policy prescriptions to date have addressed the eurozone’s liquidity, and not solvency, issue.
Second, the scope for policy mistakes is incredibly high. The magnitude of expansion of global central bank balance sheets together with limited historical precedence of the efficacy of such policy action means that we are in truly uncharted territory. The risk for emerging markets is policy mistakes in the developed world spilling over, resulting in a much more volatile and unstable path for fundamentals in emerging markets. The retracement across risk assets following the Fed minutes in March is testament to the extent of support the market is pricing in from continued easy global monetary policy.
Developed market central bank action is not the only source of policy risk for emerging markets. As EM central bank reaction functions shift away from inflation targeting to a more hazy combination of growth/exchange rate/inflation targeting, there is a real risk that transparency in monetary policy becomes compromised. The likelihood of forecasting errors becomes amplified with a greater chance of missing policy targets. The result is stickier and more volatile inflation expectations as economic agents experience greater uncertainty of policy objectives and policy outcomes.
Given this context, it is no surprise that most emerging markets are cautious about shifting gears suddenly and instead are looking to remain in a holding pattern with respect to monetary policy over the near-term. Figure 3 shows the comparison between the average six month forward rate in various regions compared to the current central bank target rate, indicating that currently there is very little market expectation for a change in the central bank rate. This means a period of extended pause across most emerging markets (e.g., Mexico, South Africa) and a natural pause in the easing cycles currently underway (e.g., Brazil). Both of which point to carry plus roll-down strategies in the front-end of local curves as the dominant investment theme for high credit quality local currency denominated emerging market bonds.