lthough quantitative easing has grabbed the headlines, a number of central banks around the world have enacted other extraordinary measures in attempts to manage their economies. The Swiss National Bank (SNB), for example, adopted an exchange rate peg versus the euro while increasing its foreign exchange reserves to almost 80% of Swiss GDP. Sweden’s central bank, the Riksbank, established explicit policy rate guidance more than five years ago. The Reserve Bank of New Zealand (RBNZ) has an inflation target range and has applied “flexible inflation targeting”’ for quite some time. And the Hong Kong Monetary Authority (HKMA) and the Monetary Authority of Singapore (MAS) use exchange-rate management to set monetary policy.
Each of these central banks has its own specific mandate, yet they have something in common: Their domestic asset markets are viewed as “safe harbors.” This phenomenon intensified during the European sovereign debt crisis and continues today. With increased capital inflows came high foreign ownership in their government bond markets, excessive exchange-rate appreciation, and rising equity and property markets. As shown in Figure 1, the real estate sector in some of these countries has become “bubbly.” As a result, the central banks in these economies may have to take more unconventional measures to stem the flow of capital and prevent asset bubbles.
The HKMA and MAS recognized that property prices and economic fundamentals have a “disconnect,” and announced measures to quell real estate speculation by setting loan limits and special stamp duties. The SNB, Riksbank and RBNZ have expressed concerns about a potential bubble forming in their housing markets. Since the majority of these central banks’ interest rates are low or near zero, or they set policy through the exchange rate, the ability to tighten policy to manage asset bubbles has diminished.
These banks now have to walk a tight rope, balancing bubbling asset markets against slow-growing economies and appreciating currencies, as shown in Figure 2. Raising interest rates in an effort to deflate their asset bubbles would likely attract greater capital inflows and drive currencies even higher. Instead, central banks are left with the typical stabilizers to tame asset price inflation − more capital controls through stamp and indirect taxes, levies and negative deposit rates – and/or managing the real effective exchange rate. Under pegged or managed exchange-rate policy, central banks typically tolerate higher domestic inflation for periods of time in order to slow capital flows, cool off asset prices and slow real effective exchange-rate appreciation.
In our view, managing exchange-rate appreciation may become a focus for these central banks. Ultimately, the effect could be a reversal of capital “safety” flows, with the implication that these flows may go to other “safe harbors,” where central banks are actively stimulating their economies through their asset markets.