Many year-end reviews of market behaviour in 2012 have rightly argued that the role of the central banks has once again proven critical, trumping all other factors, including the state of the global economic cycle. In fact, two brief statements by ECB President Mario Draghi have been the decisive events in the global financial system this year.
The first, which actually took place in the early hours of a eurozone summit on 9 December 2011, was Mr Draghi’s favourable assessment of the latest political moves towards fiscal union. This unleashed the ECB’s Long Term Refinancing Operations in the first half of the year. The second, on 26 July 2012, came when Mr Draghi said that the ECB would do “whatever it takes” to keep the single currency intact. This led to the launching of the Outright Monetary Transactions programme in September. Although still unused, the mere possibility of unlimited ECB bond buying in Spain and Italy via the OMT was enough to produce a powerful rally in global risk appetite, despite mounting concerns about the US fiscal cliff.
Understanding the developing attitude of the central banks, and the effects of their actions, obviously remains central for investors in all financial assets. The “big picture” for global financial assets, involving very low government bond yields and a gradual shift of risk appetite into credit and equities, is unlikely to change until one of two events takes place.
The first would be a decision by the central bankers themselves that the era of unlimited quantitative easing must end, either because of the risk of inflation and asset price bubbles, or because of concerns about fiscal dominance over the monetary authorities. The second would be a realisation by the markets that further action by the central bankers is irrelevant because they have run out of effective ammunition. Either of these events would probably remove the central prop from the equity bull market which began in March, 2009, but neither seems very likely in 2013.
The chairman of the Federal Reserve Ben Bernanke. Getty Images
There have been three important developments in central banking in the past week, which together indicate that their approach to inflation targeting, one of the few features of pre-2007 policy orthodoxy that has survived the financial crisis, may now be subject to radical change. (See Robin Harding on the “quiet revolution” at the central banks.) It is greatly premature to declare that inflation targeting is dead, but things are clearly on the move.
In the UK, the incoming Bank of England governor Mark Carney has suggested nothing less than the abandonment of the short-term inflation objective altogether, and has mooted the possibility of a nominal GDP level target, which is a beast with very different stripes. In Japan, the new Abe government intends to impose a higher (2 to 3 per cent) inflation target on the central bank, which can probably be hit only by pushing the yen lower.
In the US, there has been a clear shift in the Fed’s policy reaction function, or “Taylor Rule”, increasing the weight placed on unemployment and reducing the weight on inflation. The nature and importance of the Fed’s policy shift has not yet been fully understood, because it was not really spelled out by Chairman Bernanke in his press conference this week.
Mark Carney will not take up his position as governor of the Bank of England until July 1 2013, but in the interim he will be speaking frequently about monetary policy in his current role as governor of the Bank of Canada. It is inevitable that his words will now be judged in a new light, especially when he makes generic comments about monetary policy, rather than specific remarks confined to the Canadian situation.
This is why his speech on “guidance” on Tuesday was so interesting. Although he stated that this speech did not contain any direct signals about policy in Canada or anywhere else, it did give clear indications about his general thinking on the future of unconventional monetary easing. To add, his thinking appears to be different in several important respects from that of the Bank of England’s current governor and the monetary policy committee. Mr Carney is not exactly naive, and he must surely have realised his words would be interpreted in this way.
This is the time of year when the major teams of macroeconomic forecasters in the financial markets produce their annual outlooks for the next 12 months, so I would like to discuss what these forecasts are telling us about a key question facing policymakers and investors: has the 2011-2012 downturn in the global economy now touched bottom?
Although long and painful experience suggests these year-ahead economic projections will need to be revised considerably in the course of the coming year, they have been shown to contain information that is better than can be derived by naive rules (such as statistical extrapolations, for example). To add, economic forecasts are widely used to determine economic policy. Finally, investors need to know what is “priced in” to the economic consensus so they can gauge the likelihood of future surprises that will have an impact on asset prices.
The chancellor’s Autumn Statement exactly marks the halfway point in the current UK parliament, and sets a course for the next election which will now be hard to change. When the coalition embarked on its economic strategy in 2010, it was fully expected that there would be a bleak electoral patch in mid-term, but the Treasury believed that the strategy would be seen to be successful by 2015. In point of fact, however, the mid term blues have been worse than predicted, and GDP forecasts for the remainder of the parliament have been sharply downgraded.
Mr Osborne has reacted to these developments by amending his budgetary strategy in two respects. First, he has allowed the fiscal stabilisers to operate in full, so the effects of the GDP downgrades have been reflected in extra public borrowing in 2011/12 and 2012/13. Sensibly, he has not been overly rigid and there has been no attempt stick to his original fiscal path. As a result, there has been almost no tightening in the underlying fiscal stance this year, and the planned tightening for next year is about 1 per cent of GDP, similar to the plans in other major economies.
Second, he has extended the time period over which the fiscal austerity will take effect, so that his formal fiscal objectives will be reached in 2016/17, instead of 2015/16. The fiscal stance will tighten by about 1 per cent of GDP in each of the next 5 years. The same amount of fiscal austerity, spread over a longer period, is the consequence of these changes.
The Japanese election on 16 December is attracting intense interest in the global financial markets. In part, this is because the LDP’s election campaign, led by Mr Shinzo Abe, is based on forcing an entirely new monetary strategy on the Bank of Japan, with obvious consequences for the yen and the equity market.
On top of that, the Japanese election is the first in a major democracy where the role and mandate of the central bank has taken centre stage in a national political campaign. Is this the shape of things to come in other democracies facing low growth, subdued inflation and rising government debt ratios? Politicians in many other developed economies will be watching the Japanese experiment with rapt attention.