his issue of the Global Central Bank Focus features commentary from Tony Crescenzi on monetary policy and investors’ faith, Ben Emons on the potential for competitive quantitative easing, Andrew Bosomworth on the European Central Bank, Lupin Rahman on emerging markets and Isaac Meng on China.
Americans in their youth are fed a steady diet of optimism beginning appropriately in elementary school with inspiring history lessons about the dramatic birth of America in 1776. American history books are replete with animated pictures of the hodgepodge of ordinary people who spiritedly took to arms and valiantly fought against a formidable enemy to gain their independence. The story of the Revolution is indeed at the foundation of America’s optimism, and it has been reinforced time and time again throughout America’s renowned history by a plethora of inspirational events, many of which transpired as a result of sheer determination. America’s can-do spirit is captured well with this quote from Thomas Edison, the famous American inventor:
“Genius is 1% inspiration, 99% perspiration.”
In addition to American history lessons, optimism is instilled early in America’s youth through a variety of other channels, including swashbuckling movies that feed and nurture the imagination, and professional sports, which provide innumerable awe-inspiring illustrations of individuals accomplishing great feats of excellence, so often by determination alone.
Growing up in the 1970s I had a plentiful dose of optimism injected into my veins. I went to elementary school in New York in “Historic Richmond Town,” a town where colonial America is kept alive, a place complete with 30 original historic structures, including a tin smith shop, a general store and a print shop along with people dressed in colonial apparel. One can’t help but feel a connection to colonists and the Spirit of ’76 in that town, and watching Americans land on the moon during the Apollo mission made it seem to me that Americans could do anything, and I felt that way, too. Heck, I aspired to be an astronaut for years (until I realized I could barely ride merry-go-rounds without my head spinning!).
Sports inspired me as it does others. Baseball was the first sport I took to, and the 1973 Mets were the first team I followed. The team included Willie Mays, The Say Hey Kid, who belted 660 homeruns and made the amazing over-the-head catch in the 1954 World Series that was as can-do as you could get. It also included Tug McGraw, the team’s closer and father of the famous country singer Tim McGraw. Following a great year in 1972, Tug fared poorly in 1973 until the last day of August, compiling an awful 5.05 earned run average and adding to the many reasons the Mets were in last place when August ended. Nevertheless, like a true colonist, defeat was not in McGraw’s blood, so he rallied himself and his team with a phrase that became a rallying cry for all of New York City:
“Ya Gotta Believe!”
McGraw for the rest of the season performed remarkably, going 3-0, saving 10 games and posting a microscopic earned run average of 0.57. His performance and his credo brought the Mets from last to first and they won the pennant!
Operation Twist and the Leap of Faith
Just as Tug McGraw prodded his teammates (as well as New York City) to take a leap of faith and believe they could win, Federal Reserve Chairman Ben Bernanke is asking his team – global investors – to take a leap of faith in the U.S. economic outlook and thereby move out of low- and zero-yielding assets into riskier assets. This leap of faith, after all, is the essence of the Fed’s first two rounds of quantitative easing (QE), popularly dubbed QEI and QEII.
In removing interest rate risk from the bond market – by removing “duration,” the Fed through QEI and QEII prods investors to move out the risk spectrum. Call it a rebalancing effect – QE actually never was QE, because that entails banks lending their $1.6 trillion of excess reserves and expanding the money supply, which amid a liquidity trap just ain’t happening, as they say. The goal is to boost asset prices and loosen financial conditions to promote increases in aggregate demand to spur economic growth.
Choppy Financial Conditions
The Fed can remove additional duration from the bond market by extending the average maturity of its $1.65 trillion of Treasury securities. Such an operation would be a modified version of Operation Twist, which was the 1961 initiative effort by the Fed and the Kennedy Administration to lower long-term interest rates. In Operation Twist the Treasury increased the size of its auctions of short-term debt at the same time that the Fed increased the size of its purchases of long-term securities, producing a “twist” that lowered long-term rates and flattened the yield curve.
Today, the Fed’s menu of options for stimulating economic growth is shrinking and the costs and risks of another round of QE are deemed high, so the Fed will likely choose less delectable options such as Operation Twist (or ”pancake,” as I like to call it because of the way the Fed is flattening the yield curve). The goal is the same as it was for QE: to spur investors to take a leap of faith and believe that the U.S. economy will avoid a double-dip and instead achieve sustainable growth.
The Fed, amid a pitiful display of self-aggrandizement by politicians in Washington at a time of great national challenge, must out of necessity take actions such as Operation Pancake to once again build a bridge to a time when the fiscal authority finally addresses the structural impediments to economic growth and job creation. Thus far, it has been a bridge to nowhere, and investors are becoming less willing to cross the bridge.
The Fed nonetheless will try to tap into the indomitable American spirit and prod investors to take yet another leap of faith when they plead again, “Ya Gotta Believe!”
Global Competitive Quantitative Easing
In March of 2009, central banks began a campaign against deteriorating financial conditions. When the Bank of England announced quantitative easing, the Federal Reserve and several other central banks, including the Bank of Japan and the European Central Bank, followed suit. In the 1930s, the U.K. abandoned the gold standard, allowing a devaluation of the pound, and several other countries followed with devaluations. They were known as competitive devaluations, since they sought to boost trade. In 2009, major developed economies experienced severe recessions for similar reasons – credit contraction – and so central banks acted in their own interest. Central banks followed each other in a competitive way, absent a coordinated response. And so quantitative easing was dubbed “competitive QE.”
During QEII, U.S. negative real rates together with uncertainty over the Eurozone debt crisis led to a flight out of the dollar and into emerging market currencies as well as perceived “safe havens” like the Swiss franc. Since the dollar remains the reserve currency, negative U.S. real rates present a choice for global central banks to accept or reject a deflationary impulse from real effective exchange rate appreciation. The choice has become more urgent as downward adjusted growth expectations resulting from fiscal austerity combined with financial market stress have heightened the risk of a liquidity trap.
Central banks could respond to a liquidity trap with tools to make their real rates and currencies as unattractive as possible. Recently, the Swiss National Bank did this by announcing an explicit floor on the Swiss franc. The Bank of Japan responded by expanding its asset purchase fund, while Japan’s Ministry of Finance assisted by unilaterally intervening in the Japanese yen. The G-7 released a communiqué advocating close consultation in regard to actions in exchange markets and appropriate cooperation. Next, the European Central Bank coordinated with the Fed, the Bank of Japan and the Swiss National Bank to offer three dollar liquidity auctions until year-end, but that is a stopgap and not a sign of grand cooperation.
In an environment where large fiscal adjustments are required, central banks rely on mechanisms that are effective. Indirectly through asset purchases or liquidity injections, central banks could competitively devalue their currencies. As competition intensifies, cooperation and coordination among global central banks could diminish and engender a timing dilemma for policy reversal. At the same time, decisions may become asymmetrical as central bank actions are not synchronized but rather self-centered. Both cases of Switzerland and Japan showed by targeting the currency in reaction to flight to safety and negative real interest rates, each central bank acted on its own in a non-cooperative manner, contrary to what the coordinated dollar liquidity action suggests.
Figure 2 depicts that along the distribution of the world’s average real policy rates, there is a very wide range of inflation outcomes. As a competitive process in central bank decisions continues, greater inflation volatility increases uncertainty in global economies and financial markets. The following sections in this commentary explore how individual central banks in developed and emerging markets are dealing with this uncertainty.
Praise and Pity the ECB
Praise the ECB. Its mandate is price stability, and this it has resolutely delivered: 2% inflation on average since 1999. We must also show empathy with the ECB. As Europe’s crisis accelerates it is the only institution holding the euro together. Yet it is being fiercely criticized for doing so and has lost two of its leaders, first Axel Weber and now Jürgen Stark, over apparent disagreements about its controversial government bond purchasing policy. This has damaged its credibility. And it reveals how fragile Europe is. Capital flight is accelerating from periphery countries, risk premia continue to rise and trust in the euro’s construction is low. In short, the euro faces an existential crisis. What can the ECB do?
Earlier this year I argued in favor of higher interest rates, saying they were necessary to anchor inflation expectations. Developments over the last few months have changed my view. Prospects for global growth have deteriorated, with slippage in external demand and commodity prices. Capital flight from periphery countries and from banks exposed to them has tightened financial conditions. These developments are having two profound and detrimental effects on Europe’s economy.
First, banks’ ability to channel credit to the real economy is impaired. Europe’s banks have raised little capital, harbor significant sovereign risk exposures on their balance sheets and face daunting refinancing costs. Those exposed to the periphery are deleveraging as liquidity is pulled from them. Second, periphery countries are responding to the bond market’s loss of confidence in them by tightening fiscal policy. And fiscal policy in core countries has reached a limit where it can ill-afford to act counter-cyclically. Fiscal policy in Europe will thus be neutral at best, at worst pro-cyclical.
The least the ECB can do is cut rates. We expect the main refinancing rate to be back at 1% by March next year, possibly sooner and lower. It could also restart buying covered bonds now that the market is teetering on the verge of closure. And now that it has started buying Spanish and Italian government bonds, it cannot quit. To quit would likely push these countries to the verge of default. Arguably, that is what is needed to prompt reform. Whatever the ECB decides, however, its actions can only be a bridge to a destination shaped by governments’ fiscal and growth policies.
The ECB cannot provide long-term solutions to the euro area’s debt overhangs and design faults. In a fixed exchange rate system without common fiscal resources, it is not sustainable for some countries to run large and persistent current account surpluses while others run equally large deficits. Governments must therefore implement growth enhancing structural reforms, correct both surplus and deficit external imbalances and construct their fiscal governance structure in a sustainable and democratic way. Without growth or fiscal transfers, the debtors in the periphery will eventually default and the euro will experience the breakup markets are threatening it with. Pity the ECB.
Will Emerging Markets Take Up the Stimulus Mantle?
As the global growth outlook deteriorates and prospects of significant policy stimulus in advanced economies wane, a critical question is whether emerging markets will take up the stimulus mantle and attempt to reflate their economies and cushion global economic activity.
Recent decisions in Poland, Korea, Indonesia and the Philippines to keep policy rates unchanged, as well as Peru and Mexico’s dovish monetary policy committees’ (MPC) minutes reflect the “wait-and-see” mode that emerging market central bankers have taken in recent months. This cautious approach is likely to continue in the near term, especially until there is more clarity on how much of President Obama’s stimulus plan is likely to be implemented and whether the ECB will continue to provide bridge financing to the Eurozone.
For some emerging markets, central bankers are already shifting towards a more accommodative stance – for example, Brazil’s surprise -50bps cut in August to 12% where the MPC highlighted the impact of the deteriorating global environment on domestic financial conditions and inflation. The ripple effects of this decision – notably by one of the more hawkish emerging market central banks – should not be taken lightly given the small club that global central bankers are part of and the growing realization that further large-scale policy stimulus from advanced economies is unlikely to be forthcoming anytime soon. Whether emerging markets provide the globe the stimulus of last resort depends on their willingness and ability to take on this role.
Macroeconomic conditions in EM remain highly linked to growth prospects in the U.S. and Europe, pointing to aligned policy objectives in the current global environment. This is distinct from the first half of 2011 when emerging markets were grappling with surges in capital flows, closing output gaps and accelerating inflation. The result then was resistance to the “forced” global reflation imposed by the Fed’s QEII policy. This time around, global headwinds for both emerging market growth and inflation mean greater scope and willingness for policy loosening by EM policymakers.
There is also scope for emerging markets to run countercyclical policy. Monetary policy normalization had already started in many countries so, essentially, earlier hikes can be removed. The implication is that emerging economies can lower rates in the face of external headwinds given the lower levels of external vulnerability as compared with previous EM crises. At the same time, relatively low levels of leverage in emerging market balance sheets as compared with advanced economies means that there is capacity to implement expansionary fiscal policy to stimulate growth.
So does this mean global stimulus will now come from emerging markets? Not quite. There is an important caveat that this time around policy dry powder is more limited than compared with pre-Lehman. Lower levels of policy rates, albeit still some way from zero-bound, mean that the scope for monetary loosening is lower than before. Meanwhile, there has been much less normalization in fiscal policy with fiscal deficits in EM remaining in negative territory at approximately -2% of GDP currently vs. balance pre-crisis for EM as a whole.
The combination of these monetary and fiscal constraints, combined with a much more uncertain global environment, mean we may see a different policy reaction from EM policymakers than during the 2008 crisis. This time around while EM countries may accommodate any sharp downdraft in their growth, the extent to which they are willing and able to do this is likely to be lower than before. This is in part based on lower effectiveness of the available policy levers but also a recognition that the global economy is likely to be operating at lower rates of growth than before. The implication for investors is that with no one to take up the baton of global stimulus, local duration in select emerging markets (e.g. Brazil and Mexico) will continue to remain attractive.
Staying the Course of Monetary Tightening
Despite signs of growth moderating, China’s consumer inflation stabilizing and heightened uncertainties to global growth and market stress, Chinese policymakers and the People’s Bank of China (PBOC) have not lessened their vigilance. The PBOC and political leadership consensus insist on “price stabilization” as the first priority into year end. The less stressed but equally important concerns are systemic risks as a result of overly expansionary policy in 2009 to 2010, excess debt of local governments, shadow banking and property speculation.
In its policy outlook, the PBOC argues against reversing tightening policy and refutes claims that monetary conditions are too tight for small and medium enterprises. (They do give some weight to flexibility and monitoring external uncertainties.) This tightening bias was confirmed recently by a surprise imposition of the effective 1.2% required reserve ratio hike for commercial banks through year end. The PBOC also shifted its policy preference from credit curbs to normalizing low interest rates and a rigid exchange rate policy, though it is the political leadership rather than the PBOC who have the final say on the benchmark interest rate and the exchange rate. However, within its realm of discretion the PBOC seems to be actively influencing money market rates and accelerating the Chinese yuan fixing.
Into year end, the PBOC will likely continue this late tightening cycle, though further quantitative tightening seems less likely after recent reserve ratio hikes. Money market liquidity, however, should remain tight and we see a near even chance of another quarter point interest rate hike if inflation fails to quickly moderate below 5%. As long as external weakness does not turn into full-blown crisis, the PBOC will likely continue to push for greater yuan flexibility, tolerating perhaps more than 5% annual appreciation.
If the global outlook does deteriorate sharply, there is room for the PBOC to adjust policy through liquidity easing. However, the PBOC and most policymakers strongly oppose re-pegging the yuan to the dollar when going into political succession in the next 12 months. It is therefore politically difficult to cut interest rates while they are still 2% negative in real terms or to ease macro prudential measures on local government financing vehicles and property.