aul McCulley, a minister’s son, said in January 2000 in his first regularly produced PIMCO publication on central banking – then titled Fed Focus – the following:
“The job of a Fedwatcher is very similar to that of the theologian: Identifying the dogmas and catechisms of the secular god of money creation, and within that paradigm of understanding, forecasting feasts and famines for particular asset classes.”
It is said that the more times change, the more they stay the same. Times certainly have changed, but Paul’s words ring as true today as ever: Forecasting the ultimate performance of particular asset classes requires investors to do far more than put their money to the wind and pray; above many other influences they must understand the many ways that central banks influence the behavior of economies and markets. The adage “Don’t fight the Fed” therefore remains powerful advice to heed.
Still, there is much more that investors must do if they are to successfully guard and grow their capital. In particular, investors must see the world through new eyes, because the world of finance in a decade has been turned upside down – the sources of global economic growth and the seat of financial power have made a titanic shift away from the developed world. Thus it behooves investors today to drop their home bias and scour the globe for sources of value and investment opportunities. This requires investors to expand their view of the world of central banking beyond the Federal Reserve to include analyses of the policies and activities of the rest of the world’s central banks, because, as Paul noted in his first edition of the renamed Global Central Bank Focus in May 2006, “Fed policy is no longer the sole straw stirring the global liquidity drink.”
New Levers and the Ravages of Coinage
The influence of the world’s central banks on the capital markets remains as strong as ever. Today, central bankers are not just referees of the capital markets, they are also players; they are price setters. This is true in particular of the Federal Reserve, the European Central Bank, and the Bank of England, each of which has engaged in securities purchase programs to battle the financial crisis.
As new as the influence of central banks on asset prices seems, is it really new? Have central bankers only recently learnt the power of pulling the monetary lever or did they merely find more levers? The answer is certainly the latter; those with the power to print money have for centuries held influence over the populace. This was true well before there were central banks and it reminds us of the dangers of turning to coinage – or at least today’s electronic version of it – as a means of shedding debt.
History is laden with failed attempts at creating new money to shed debt. Greek tyrant Dionysius of Syracuse, now Sicily, at around 400 B.C. resorted to coinage debasement when his fortunes declined. Germany, of course, debased its currency before World War II, leading to hyperinflation. More recently, Zimbabwe printed massive amounts of currency, also leading to hyperinflation – I purchased trillions of Zimbabwe dollars on eBay for a few U.S. dollars! Such are the ravages of excessive use of the printing press.
The Monetary Trilemma
The consequences of the debasing of currencies have been readily transparent for ages. Yet, in one form or another, nations in the developed world are resorting to their virtual printing presses to revive their economic fortunes. In the United States, the Federal Reserve has used its authority to engage in the purchase of roughly $2 trillion of financial assets, an activity that increases the quantity of bank reserves, the money that banks use to expand the money supply – to increase coinage, in other words. This, in theory, puts at risk the purchasing power of the U.S. dollar. The hyperbole over stripping the Fed of its independence therefore is just that, leaving the Fed able to continue its efforts to reflate the U.S. economy, but also creating risk for the U.S. dollar.
In the U.S. and in the rest of the world, nations face a trilemma, where one objective must be sacrificed in order to achieve the other two. Here are their choices:
- Monetary policy independence
- Exchange rate stability
- Free flow of capital
Owing to its large budget deficit, the U.S. cannot sacrifice capital mobility, because it needs funding. As mentioned, no sacrifice of monetary policy independence is in the offing – certainly not to any foreign entity and not to the fiscal authority, either. This means the U.S. has chosen to sacrifice exchange rate stability.
The European Central Bank (ECB) is engaging in quasi-fiscal transfers by purchasing the sovereign debts of peripheral Europe. The purchases result in excess liquidity in Europe’s banking system and at the same time contaminate the ECB’s balance sheet, risking the purchasing power of the euro. Having selected monetary policy independence and capital mobility, Europe too is therefore sacrificing exchange rate stability. Internally, Europe’s periphery has actually had to sacrifice two objectives: independent monetary policy and exchange rate stability. Europe faces a particularly daunting challenge trying to balance between its so-called fiscal and monetary corridors, as Ben Emons describes in his section (below).
On the opposite end of the spectrum, nations with surplus funds – which in today’s upside-down world include China, Brazil, South Korea and Russia, to name a few – wish to control the growth of their surpluses in order to keep economic activity from increasing too rapidly and inciting inflation. In other words, surplus nations are choosing to sacrifice capital mobility for the ability to keep monetary policy independence and exchange rate stability. Lupin Rahman describes in her section (below) how policymakers within the emerging markets will contend with the monetary trilemma in the year ahead.
In game theory, in a non-cooperative game such as the trilemma above, each of the participants acts out of self-interest, resulting in big winners and losers. In today’s multi-speed world, central bankers are for the most part acting unilaterally, serving their own interests. For the foreign exchange markets, the investment implications are fairly obvious – indebted nations must sacrifice exchange rate stability if they are to correct the imbalances they have with the rest of the world. For the interest rate markets, efforts by indebted nations to reflate their economies will eventually erode the value of money, thus posing risk for holders of long-term government securities.
Concrete Casks and Yucca Mountain
Numismatists understand well the relationship between supply and price because in their hobby of collecting coins, the quantity of a particular coin relative to demand affects its price a great deal. Notaphilists are the same, only their familiarity comes from the collection of paper currencies. Scripophilists understand the relationship, too, from their experience in collecting paper stock and bond certificates. Philatelists – stamp collectors – know a thing or two about the laws of supply and demand, too. An understanding of the basic relationship between supply and price is what prevents, say, a numismatist from being fooled by a novice who tries to sell him or her for a “song” a copper Chinese coin that was minted about 1,000 years ago during the Song Dynasty. The numismatist knows that literally billions of such coins were produced in the year 1085, for example, in factories across China.
Only Banks Can Create Money Supply
Debasement of indebted nations’ currencies depends importantly upon the excessive creation of money. Today, the deleveraging process is preventing this from happening. This brings us to a critical point: By themselves, increases in the quantity of bank reserves resulting from central bank activities cannot boost the money supply; only banks can create money supply. To illustrate the point, let’s look at a sample T-account (that is, a basic two-column accounting table; see Figure 1) for a U.S. bank and its customer.
ABC Company borrows $20,000 from XYZ Bank, which, like all banks, is an intermediary between the Fed and the public. Banks, in fact, are the only entities allowed to offer checking accounts.
As the T-account shows, the immediate effect of the loan is to increase total demand deposits by $20,000, but no decrease has occurred in the amount of currency in circulation. Therefore, by making the loan, XYZ Bank has created $20,000 of new money supply.
The ability of banks to create loans and thus boost the money supply is what worries those who focus on the quantity of reserves that the Federal Reserve has injected into the financial system. Roughly $1 trillion of excess reserves sit in the U.S. banking system as a result of the Fed’s asset-purchase program, which is about $1 trillion more than normal – banks typically would rather lend their excess reserves than leave them deposited at the Fed (Figure 2) where they earn next to nothing.
In normal times, the banking system can turn one dollar of reserves into about eight dollars of new money supply, because a bank can lend 90 cents on the dollar after putting 10 cents aside at the Fed for a reserve requirement. A bank on the receiving end of the 90 cents can lend out 90% of that, or 81 cents, and so on and so forth until presto: One dollar becomes eight dollars. This is why the monetary base, which represents the money, or reserves, injected into the financial system by the Federal Reserve, is called “high-powered money.”
Bank reserves in their enormous quantities therefore are toxic, but in the same way that nuclear waste is of no danger so long as it is tucked away either in Yucca Mountain or concrete casks, bank reserves are of no danger to fueling inflation so long as they are held at the Fed. When the concrete cracks – when banks utilize their excess reserves and lend again – the Fed must remove the toxins, beginning first with technical operations such as reverse repos, but ultimately ending with rate hikes. This is the expected sequencing.
The Fed’s Commitment on Rates
Gains in the real economy by themselves won’t be enough to prompt the Fed to raise interest rates for quite some time, because the level of economic activity will remain low relative to the economy’s potential for the foreseeable future. In order for the Fed to break its commitment on rates, one of its three conditions for keeping the commitment would have to change:
- Low resource utilization (for example, the high unemployment rate)
- Subdued inflation trends
- Stable inflation expectations
Only the third condition has the potential to change in any meaningful way this year, because the unemployment rate is almost certain to remain high and as a result inflation will stay low. Inflation expectations could nonetheless become less stable if, following many months (six, at least) of strong employment gains and/or gains in bank lending, the Fed indicates it has no plans over the medium term to reduce its degree of accommodation. A less-stable level of inflation expectations would occur at levels above the long-term trend of around 2.50% for 10-year TIPS (Treasury Inflation-Protected Securities), say when inflation expectations reach 2.75% on a sustained basis and trending higher, and at around 3.25% and trending higher for the 5-year/5-year (the level at which market participants expect five-year inflation expectations to be in five years).
The Forward Curve Will Be Right… Someday
It has paid for many quarters now to bet against interest rate hikes embedded in forward rates. Extant in the forward curve implied by Eurodollar futures are Fed rate hikes priced to occur as early as the end of this year. If economic activity accelerates in the way that many expect, increases in forward rates in 2011 will be associated more often with increased speculation about rate hikes than was the case in 2010. The emphasis here is on the word “speculation” – the market is almost certain to romance the idea of a hike well before an actual hike occurs. This is a bit different than in 2010 when the cause of increase in spot and forward money market rates was nearly always concern over credit conditions rather than concern about either liquidity or increased speculation about future Fed rate hikes. There was only one occasion, in April, when speculation about future rate hikes intensified, but the speculation was mild. Decisions in 2011 about whether the forwards will be validated need be taken with a bit more care than in 2010 owing to the strengthening of the U.S. economy, but the base case is that there will be no rate hikes.
As I said, when banks begin to utilize their excess reserves to make new loans and create new money rather than store the reserves in “Yucca Mountain,” the case will then grow for the Fed to begin removing the reserves. This has not happened yet (Figure 3), but when the process begins it will be evident from the Fed’s weekly H.8 report on the assets and liabilities of commercial banks.
We Will Know It When We See It
Paul McCulley faced in January 2000, as Fedwatchers constantly do, a question over when the Fed might begin to reverse its interest rate policy. He presciently described the endgame for that era, expecting it to unwind in four stages, concluding that short rates would “reach a sufficiently high level to ‘crash’ stocks,” thereby weakening the economy and “ushering a reversal to Fed easing.” How right he was: The Fed hiked rates until May 2000 and the financial bubble burst.
Paul said in his article that he didn’t know when the events he predicted would happen, but he reminded readers that PIMCO is paid to “know it when we see it.” In this vein, when we at PIMCO are asked when the Fed will reverse its current stance on interest rate policy, we will echo Paul’s words and say that we will know “it” when we see it. We plan to earn our pay.
Across the Pond and Around the World
Now, let’s turn to my PIMCO colleagues for discussions on central banking in Europe and the emerging markets. Comments from PIMCO experts throughout the world will be a regular feature of future editions of the Global Central Bank Focus.
European Central Bank Focus
The ECB has been normalizing its monetary policy stance since the middle of 2010, advocating a “separation policy” between its standard and non-standard measures. By controlling excess liquidity, the ECB stresses that it can adjust the level of its policy rate (refi rate) separately. The difference between standard and non-standard policy measures is observed as the “bias” driven by the level of the effective policy rate, known as EONIA (Euro OverNight Index Average), a rate that at any time can run at or below the actual policy rate.
The ECB manages the bias within a corridor system consisting of the policy rate, the lending rate and the deposit rate. This is the so-called monetary corridor. From late 2008 the bias has been towards easing but has, since the middle of 2010, been gradually reduced (Figure 4). Market expectations show that by year’s end the ECB’s policy normalization will be complete, as the effective rate (now 50 basis points, or bps) will then be close to 1%, the level of the policy rate.
Importantly, the ECB’s policy rate can be significantly influenced by the level of the inflation rate relative to the ECB’s inflation target of around 2%. As Figure 4 shows, in the past and in particular in 1999–2001 and 2008, the ECB quickly hiked its policy rate when inflation rose by one to two percentage points above its target. The reverse happened when the inflation rate fell below target. The recent acceleration in inflation in the eurozone above the ECB’s inflation target would normally have enticed the ECB to signal tightening. The global financial crisis has prevented this by forming a link between the ECB’s policy rate and its non-standard measures, a link that has now become more deeply embedded in the construct of the ECB’s functioning as a result of the sovereign debt crisis.
This link has complicated the ECB’s ability to respond preemptively to the acceleration in inflation, as it has had to intervene in peripheral bond markets to counter speculation over sovereign defaults in peripheral nations. The uncertainties surrounding Europe’s sovereign debt dilemma put pressure on the wholesale funding markets for Europe’s banks, which the ECB in turn has to counter by providing excess liquidity. Thus, although inflation is running above the ECB’s target and market participants have slightly shifted rate hike expectations ahead to the second half of 2011 (from 2012), the ECB is confined to its monetary corridor in order to provide sufficient stability to the bond markets.
Bond market stability has become even more important as the European Financial Stability Fund (EFSF) is having to issue bonds to fund the emergency aid the European states have agreed to provide Ireland. The lending rate for the EFSF established in the aid package to Ireland and Greece is approximately 7%. In order to fund loans that come from the EFSF, bonds will be issued at a borrowing rate estimated currently at 2.75% to 3.00% (based on a weighted average of the borrowing rates).
Thus, the EFSF mechanism is also a corridor, a “fiscal corridor” that represents the governments’ emergency borrowing and lending mechanism.
As indicated by the circles in Figure 5, which plots the EFSF fiscal corridor versus the ECB monetary corridor, each time a crisis has occurred the ECB has had to intervene in the fiscal corridor while maintaining ample liquidity in its monetary corridor. The central bank therefore has to strike a balance between the two corridors that is more forced than natural. This is essentially another “trilemma,” as the ECB has to stabilize the prices of bonds, consumer goods and excess liquidity at the same time.
Trying to achieve all three will ultimately lead to a difficult trade-off: The ECB must choose whether to stabilize bond prices by keeping liquidity abundant, and hence let inflation run above its target rate, or tighten monetary policy perhaps significantly to control inflation. Until such time that sovereign default risk is fully stabilized, the ECB must maneuver delicately between the fiscal and monetary corridors. It can only do so if the policy rate remains at 1% even as it uncomfortably monitors inflation expectations. Such forced balance is likely to remain a central theme for 2011.
Emerging Markets Central Bank Focus
The combination of strong growth, increasing interest rate differentials and improved creditworthiness has resulted in a surge in capital inflows into emerging markets, in turn causing upward pressures on their exchange rates. At the same time, emerging markets face growing inflationary pressures as output gaps close and higher food prices lead to second-round effects on core inflation.
Emerging market policymakers thus face a policy conundrum: If they raise policy rates to ward off inflation they risk attracting even more capital inflows and causing further unwanted appreciation of their currencies. These choices are compounded by fears of asset market bubbles, a reversal in risk sentiment and loss of export competitiveness against a still uncertain recovery in developed markets. Here, again, is the monetary trilemma – the delicate balancing act among independent monetary policy, a fixed exchange rate and the free flow of capital. How emerging markets policymakers grapple with this trilemma will be a key theme in the coming year.
Here is what we expect:
- Gradualism in monetary policy normalization, with emerging market central banks favoring incrementalist over front-loaded hiking cycles. To date, emerging markets have reversed on average only a fraction of the aggregate monetary loosening since the crisis, with the majority of economies remaining on hold. The implication is much smaller and more gradual hiking cycles than markets are currently pricing in (Figure 6). For example, in Brazil the roughly 200 bps of hikes priced into the local curve seem aggressive given the cumulative 250 bps of hikes already implemented, along with the Rousseff administration’s strong commitment.
- Increased reliance on foreign exchange intervention and ad hoc, unorthodox policy tools as policymakers grapple with containing surging inflows and rely increasingly on non-interest monetary tools to tighten monetary conditions. Recent examples include Chile’s $12 billion currency intervention program and Brazil’s reserve ratio requirement increases for domestic banks as a means to limit domestic credit growth.
- Increased differentiation across emerging markets given divergent initial conditions and differing policy objectives. Latin American economies, where real exchange rates are close to pre-crisis levels, are less likely to be tolerant of further appreciation pressures compared with Asian economies where more limited real appreciation and prospective appreciation of China’s yuan pose strong economic tailwinds. Meanwhile, emerging European economies faced with potential contagion from the eurozone periphery are more inclined to concentrate policy to safeguard against a reversal of capital flows.
- Continued importance of global factors, including U.S. rates, eurozone contagion and global risk sentiment. Market expectations of a U.S. recovery and the associated path for U.S. rates are likely to have a disproportionate impact on emerging market local rates given that the developing economies’ macroeconomic recovery has been more or less priced in while global factors remain unpredictable. Along the same lines, risks of a tail event in the eurozone peripheral crisis together with a repricing of risk assets across all sectors have potential to drive sharp bouts of outflows from emerging markets in spite of the strong underlying fundamentals driving structural flows.
In spite of these policy challenges, the macroeconomic outlook for emerging markets as a whole remains constructive. Notwithstanding the increased potential for ad hoc policies and associated risks, emerging markets overall will likely see normalization in the stimulus measures implemented during the crisis, including partial tightening in monetary conditions, fiscal consolidation and some currency appreciation. What this adds up to in terms of the outlook for 2011 is real GDP growth rates of 6.75%–7.0% and inflation increases in the 5.75%–6.0% range for the key markets of Brazil, Russia, India and Mexico.