This issue of the Global Central Bank Focus features commentary from Tony Crescenzi on necessary central bank actions in Europe, Ben Emons on policy tools and targets, Andrew Bosomworth on the options available to the European Central Bank, Lupin Rahman on diverging monetary policies in emerging markets and Rob Mead on the monetary outlook for Australia. 

The world is playing a game of hot potato with European financial assets and the only player with oven mitts is the European Central Bank (ECB). The ECB nonetheless is a reluctant and only part-time player in a game where the number of players and hot potatoes is increasing by the day. As a result, some of these potatoes are falling to the ground, mashed.

The ECB is, as Andrew Bosomworth discusses below, reluctant to expand the traditional role that central banks play as a lender of last resort by applying it in this case to governments as well as banks. It is reluctant, in other words, to provide a bridge to a time when Europe’s authorities get their fiscal houses in order. Part of the reason is philosophical and relates to the ECB’s raison d’être, which is to control inflation. Another is Article 123 of the Lisbon Treaty, the agreement that binds the European Union. Article 123 prohibits the ECB from making direct purchases of government bonds in the primary market.

Look no further than the back of a euro banknote for a symbol of how Europe has failed in its long-stated goal of cooperating closely not only with each other but with the rest of the world, which today is at the mercy of Europe and the fate of its currency union. On the back of each note is a bridge, meant to symbolize the close ties among European nations and the rest of the world. Like the hoped-for cohesion, the bridges are fantasy – they’re all fake, generic representations – Europeans never decided on any real ones to show. Call them bridges to nowhere and until policymakers bridge their divide, the ECB and indeed the rest of the world will be hesitant to take the risks necessary to save the eurozone.

In the meantime, Federal Reserve Chairman Ben Bernanke continues to show he is one of the few true deciders these days on the global policy stage. On 30 November, the Federal Reserve, along with five other central banks including the ECB, announced enhancements to their existing U.S. dollar liquidity swap arrangements. These provide for the Fed to swap dollars in exchange for other currencies, in unlimited amounts, through 1 February 2013, at a rate of about 60 basis points (bps) – down from about 110 bps previously.

For Europe, the swap line enables the ECB to borrow dollars and then lend those dollars to European banks, which are sorely in need of funding because the world is playing hot potato with their debts, too. As an illustration of this run on European banks, note the sharp reduction in exposures to European bank debt by U.S. institutional prime money market funds. For years, prime money funds invested about 50% of their investable money in European banks. This lasted until June. Since then, data from Fitch indicate the tally has fallen to 35%. Further evidence of strain has been in the interbank market, in particular LIBOR (the London Interbank Offered Rate). Whereas in June 3-month LIBOR was 0.25%, it is today at 0.54%. Moreover, forward rates on LIBOR are priced for 3-month LIBOR to eventually reach about 65 bps. Keep in mind that any use of the Fed’s swap facility expands the Fed’s monetary base: All dollars, no matter where they are deposited, whether it be Kazakhstan, Japan or Mexico, wind up back in an American bank. This means that when the Fed’s swap line is used, the Fed will create new money. This in some ways makes the swap line a backdoor way to engage in quantitative easing.

The provision of liquidity is no substitute for other actions that Europe must take to solve its current woes and the world continues to wait with great anticipation on actions Europe will take toward forming a fiscal union. Legal issues mean any “marriage” is a ways off. Nevertheless, if the ECB is to finance the wedding, it must be confident that European nations will agree to a strong “pre-nup” and actually reach the altar after what is likely to be a harrowing engagement period. Then and only then will the “guests” – global investors – feast on the potatoes they today want very little of.

The Tinbergen Rule: Right Tools for the Job?
– Ben Emons
Dutch economist Jan Tinbergen published in 1952 the “Tinbergen rule.” It was a groundbreaking economic policy insight at the time, stating that the number of policy targets needs to be in balance with the tools available: If targets surpass tools, some targets may not be met, Tinbergen argued. The rule stresses the need to design a specific policy tool for each individual target, for example, unemployment and inflation. With designated tools dedicated to separate objectives, Tinbergen believed that policy would become more effective.

This line of thinking entered global central banking by late 1990s, promoted by Swedish central bank governor Lars Svensson as “flexible inflation targeting” aimed at stabilizing both inflation and the real economy. It is a framework where tools such as quantitative easing and liquidity operations are used to smooth market conditions while at the same time guidance is given on the stance of the policy rate to help stabilize long-term inflation expectations.

An implication of duality in objectives is that thresholds are established, helping central banks maintain a balance between the different targets. These thresholds are sometimes explicit, like the recently set 1.20 limit on euro–Swiss franc exchange rate by the Swiss Central Bank. Thresholds can also be seen in financial markets price reactions, which makes them implicit, such as 6%–7% yields on Italian bonds the European Central Bank is supposed to defend, or a 75 Japanese yen–dollar exchange rate (the Bank of Japan heavily intervened to keep the yen from strengthening further).

Whether explicit or implicit, these threshold examples are reactions to the intensity of the European debt crisis and its effect on the global economy. As thresholds breach, it leads policymakers toward a self-enforced deployment of multiple tools to meet targets in an uncoordinated albeit concerted fashion. Therefore, central banks may continue to follow each other with more easing actions. The premise of Tinbergen rule now poses an important question: Are there sufficient monetary tools available globally to meet targets? If every central bank enacts quantitative easing, foreign exchange interventions or liquidity injections, those tools compete for the same targets (financial and inflation stability), thereby potentially eroding their effectiveness. Thus far, quantitative easing by the Bank of England, a covered bond purchase program by the European Central Bank and Operation Twist by the Federal Reserve (selling short-term Treasuries in exchange for longer-term) have had an impact on interest rates, but financial conditions have tightened, accentuated by Europe’s debt crisis.

Another implication of vast numbers of policy tools being activated is that their stated objectives can lose clarity; for example, quantitative easing may appear more like credit easing, largely negating its precise planned impact. The Tinbergen rule would argue that such grey areas between specifically designed tools create shortages. Shortages can lead to creativity in engineering still more tools, in turn generating effects that markets may not fully or quickly grasp. And when tools are in shortage, creativity in defining, modifying or deviating from targets may function as the alternative. For example, as inflation expectations and financial conditions fall, each central bank continues to ease uniquely and individually (Figure 2).


The Lender of Last Resort
– Andrew Bosomworth
The government bond run plaguing the euro area is taking yet another turn for the worse. Instead of reassuring markets, the latest European Union summit has sent the yield spread between German bunds and bonds from virtually all other eurozone countries soaring as banks from these countries struggle to fund themselves and the risk of a retail deposit bank run somewhere in the euro area rises materially. What began as a temporary liquidity crisis is turning for some countries into a solvency crisis.

At current refinancing rates, for example, Italy needs to achieve a permanent primary surplus worth 4.5% of gross domestic product to stabilize its debt relative to national income. However, markets are impatient, and Italy has already de facto lost market access. No wonder calls are rising for the ECB to act as lender of last resort, not just to banks but to governments too. But the ECB should not play this role for governments for free, or at least not in the classic manner.

A look at the origins of the euro area’s debt crisis and the principles of lender of last resort explains why. The euro area’s debt problem is a symptom of an incomplete fiscal structure coupled with an underlying balance of payments problem and uncompetitive labor market. Since the euro’s inception, France and several peripheral countries have borrowed about €1.4 trillion to finance a persistent current account deficit. This capital is now flowing out, hence the wholesale run on governments and banks. A lender of last resort cannot solve these problems; it can only provide a temporary bridge at best unless member states address the underlying problems.

To be sure, others may disagree. None other than Walter Bagehot, influential businessman and longtime editor of The Economist, argued in the 19th century that a central bank should lend liberally to solvent institutions in the face of a run on the banking system. The ECB already provides this feature today to banks via its standing facilities. But institutional arrangements prevent the ECB from providing it to governments, and Germany’s horrendous hyperinflation in 1923 shows how badly governments can abuse the central bank’s role.

Together, the fiscal and monetary authorities can likely avert a systemic accident, but they must act quickly and courageously. The fiscal authorities need to lay out a plan for deeper unity that goes beyond the intergovernmental agreement of 9 December. They need to decide which countries face a liquidity challenge that they will deal with, and which are insolvent that they will restructure. They need to clarify whether those countries that restructure will stay in or leave the euro.

Europe needs a better primary market tool than the unfunded European Financial Stability Facility (EFSF). We see the ECB being left with no choice but to monetize the debt of Italy, Spain and possibly Belgium, which collectively need to borrow approximately €1 trillion over the next three years. The simplest way to monetize this debt would be for the ECB to buy it outright from the secondary market; this method is laced with moral hazard but would allow these countries to maintain market access. Alternatively, the ECB could provide liquidity to the International Monetary Fund (IMF) and have the IMF in turn lend to governments, subject to conditions, a step they did agree to but one that will need more resources than the €200 billion so far indicated. In any event, the ECB should retain the Securities Markets Programme (SMP) as an unconventional secondary market tool, able to intervene to ensure government bond yields of solvent countries remain below levels that threaten debt sustainability.

Without a bold policy response, Italy could soon lose market access whenever the market decides, making default inevitable, plunging Europe into depression and ending the euro area as it is today. Rather than the hyperinflation of 1923, it is the deflation of 1932 that we should now worry about.

EM Differences Emerge
– Lupin Rahman
Differentiation among emerging market (EM) monetary policies is increasing (Figure 3). Faced with prospects of sharply decelerating growth as risks of a European recession mount, some EM central banks have opted to start cutting policy rates. Others have adopted a wait-and-see approach as significant currency depreciation and volatility have increased macroeconomic uncertainty and the risks of imported goods inflation (Figure 4). A third approach has been to raise rates as external vulnerability outweighs growth considerations. Why all the disparate approaches, when all economies are facing a common global shock?

A key driver is differences in initial conditions, with balance sheet quality a critical factor. Economies such as Hungary, where high levels of private external debt have contributed to significant external risks, are facing a classic currency crisis. Their muddled appeal to the IMF for assistance and reluctance to meet previous IMF conditions have not helped matters. Consequently the Hungarian government’s response has been that of the classic “old EM,” with the central bank recently raising rates by 50 bps to 6.50% in an attempt to defend its currency, the forint, and bolster investor confidence.

However, while balance sheets matter and are critical in whether emerging markets can lower policy rates even as their currencies depreciate, they are not the whole story. Endogenous factors such as national policy frameworks as well as market technicals are equally important in determining the path a central bank’s reaction function takes. In Brazil, for example, a strong balance sheet underpinned by low levels of external debt and high foreign reserves means the central bank has substantial flexibility to cut policy rates. In addition, the shift in the central bank’s emphasis from inflation targeting to growth, together with an aggressive fiscal consolidation planned for 2012, mean that lower rates are more likely to have structural underpinnings.

Meanwhile, in Mexico – another emerging market with low levels of external vulnerability – the policy doctrine has been to allow full exchange rate flexibility while leaving rates on hold, in effect allowing the exchange rate depreciation to loosen domestic monetary conditions and do more of the heavy lifting. This policy decision is not due to an inability to smooth exchange rate fluctuations (reserve firepower stands at $140 billion plus $47 billion from the IMF’s Flexible Credit Line), but to Mexico’s policy preference for market forces to lead price determination. This preference also points to managing market expectations via clear and preannounced policy initiatives, avoiding policy shifts that could surprise the market – for example, the central bank’s recent changes to its foreign exchange auction mechanism. Looking ahead, a more stable exchange rate together with a stringent fiscal plan ahead of the 2012 elections means that monetary policy remains the main policy lever for stimulating Mexico’s real economy in the event of a significant downturn.

Finally, market technicals will remain an important consideration in any central bank policy rate decision. The large inflows into emerging local markets and the sizable interest by fast money players in both currency and rates markets mean that some local markets are vulnerable to a sharp deterioration in a global risk-off environment. Flow data so far indicate that EM local holdings by foreign investors remain largely unchanged with currency hedges the main driver of foreign exchange weakness. With developments in Europe at a critical juncture and the risk of accidents increasing, these levels of foreign investment may be cold comfort for EM central banks. All of which point to a period of more pre-emptive announcements and policy experimentation.

Reverse at the Reserve Bank of Australia Weighs on Confidence
– Rob Mead
After hiking rates seven times post-crisis between October 2009 and November 2010, then leaving rates on hold for twelve months, the Reserve Bank of Australia (RBA) recently changed direction by cutting rates by 25 bps in both November and December to take the policy rate from 4.75% down to 4.25%. This shift was the result of a combination of global and domestic factors.

The rapid escalation in the European sovereign crisis and consequent financial market volatility, coupled with a decline in global growth expectations, have weighed heavily on the confidence and outlook of both businesses and consumers in Australia. The deteriorating global backdrop plus restrictive domestic monetary policy have nudged the rate of underlying inflation back to the middle of the RBA’s target band of 2%–3% and the unemployment rate up to 5.3%, which should ease wage pressures. This more benign inflation outlook meant restrictive interest rates were no longer appropriate.

The important question is whether this change in policy direction is a modest move back to neutral or the start of a more prolonged easing cycle. Prior to the financial crisis, a 5.50% cash rate roughly corresponded to neutral policy, but with mortgage spreads widening by around 1.25% due to higher bank funding costs since 2008, we now estimate neutral to be closer to 4.25%, the current level of rates. Looking forward, we expect the global environment to be less supportive, with lower than consensus growth forecasts for China in particular. With the Australian dollar remaining stubbornly above parity to the U.S. dollar and domestic house prices declining, broader financial conditions are set to remain tight despite neutral interest rates. Additionally, the Australian Federal Government remains committed to further fiscal tightening, with the target of bringing the budget back to surplus in the 2012–2013 year despite lower realized revenues resulting from slower-than-forecast domestic growth. For these reasons, we think the RBA will need to ease further in 2012.

Given the starting point of a strong sovereign balance sheet and neutral interest rates, there is ample scope for policy support if required. This is not to suggest that the longer-term secular outlook for Australia doesn’t remain constructive – we can expect continuing demand for commodities from China. Investment commitments in the mining sector are very strong and despite recent falls in commodity prices, the terms of trade remains near historically high levels.

However, the past six months have been an important reminder that small open economies such as Australia are not immune to the broader global business cycle despite their fates being more closely aligned with stronger growth in the emerging world in recent times. Their longer-term path remains intact, but the journey from here to there will be anything but smooth.

The Authors

Tony Crescenzi

Portfolio Manager, Market Strategist

Ben Emons

Portfolio Manager, Global

Andrew Bosomworth

Head of Portfolio Management, Germany

Lupin Rahman

Head of EM Sovereign Credit Portfolio Management


Past performance is not a guarantee or a reliable indicator of future results.This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice.  This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.