It is now almost universally accepted that the major central banks were woefully mistaken in ignoring the build up of credit risk in the years before 2008. Whether they should have acted through raising interest rates or by tightening regulations on the financial system is still under dispute, but the abject consequences of doing nothing are plain for all to see.
This has naturally made policymakers very determined not to make the same mistake again. But they are also aware that they do not want to be a group of generals focused on winning the last war. In the past, these decisions have not proved easy to make in real time. Consequently, a great deal of recent research has been aimed at doing better in future.
The Fed has been in the front line of this work, but the Bank for International Settlements has joined in with some very valuable insights and empirical work, led by Claudio Borio. Although there is clearly a very active exchange of views occurring at the Fed, the bottom line for investors is that restrictive monetary action in the US, in response to a build up of excessive financial risk, is not likely for quite some time. Read more
The legal enactment of fiscal sequestration in the US last Friday brings to an end a series of haphazard measures to tighten budgetary policy since the Obama fiscal stimulus was reversed in 2010. The overall result has been to raise $3,500 billion over the next decade, around 2 per cent of GDP.
Taken together with other measures which were already in the baseline for policy, the cumulative fiscal tightening will amount to 4.8 per cent of GDP from 2010-14, of which 1.5 percentage points will occur this year, and 0.6 percentage points will come from the sequestration order itself.
This tightening has set in stone the fiscal stance for President Obama’s second term and it will ensure that the US budgetary position is “sustainable” over that period. It is not yet clear, however, whether the economy can grow robustly while the measures take effect. Read more
Only one thing is clear after the Italian election. The comfortable assumption, which until now has been held by the policy elite in the eurozone, and mostly in the financial markets, that in the end “sensible” democracies will always support conventional economic policies has been shattered. Whichever way one dissects the electoral arithmetic, Italian voters have turned their backs on the respectable Europeanism of Mario Monti, and have handed power and responsibility to Beppe Grillo‘s Five Star Movement, whose entire platform denies that either concept should apply to them. A disparate group of unpredictable oppositionists now holds the balance of power in the Italian Senate. Read more
The major event in the global financial markets in the coming week is likely to be the nomination of a new Governor for the Bank of Japan. Very rarely does the identity of a specific individual matter so much for future central bank policy as it does in Japan right now.
The incoming government of Prime Minister Shinzo Abe has succeeded in weakening the yen by 20 per cent, and raising the Nikkei by 28 per cent, since last October. For the first time in two decades, Japan seems to have a chance of escaping from the liquidity trap. Read more
The markets were impacted yesterday by two very different sets of monetary policy minutes from the Fed and the Bank of England. In the case of the Fed, the worry is that the central bank is back-tracking on its commitment to maintain open-ended QE until the labour market has improved “substantially”. Meanwhile, at the Bank of England, the concern is that monetary policy might be too easy in the context of a declining exchange rate, and an inflation outlook that will exceed the official target for at least the next two years.
Although coming at the monetary policy problem from entirely different angles, these concerns have one thing in common. It has become increasingly difficult for both the Fed and the BoE to communicate their policy regime clearly to the markets in an environment where their policy committees have become openly split about the right stance to pursue in the months ahead. Read more
The FT recently called for a serious debate on the idea that budget deficits should be permanently monetised by the central banks. So far the most prominent response from an active policy maker has come from Lord Adair Turner, the outgoing Chairman of the UK Financial Services Authority, and a former candidate to become Governor of the Bank of England .
Lord Turner is under no illusion that his discussion of this policy option will open him to ridicule or worse in some quarters. He expects to be called a “dangerous man”, which is a strange description for this typically cerebral product of McKinsey. Yet he considers this risk worthwhile because he believes there should be a rational comparison between OMF or overt monetary finance (a less inflammatory term than the usual “helicopter money”) and the quantitative easing favoured by today’s central bankers.
In public, central bankers like Ben Bernanke, Mark Carney and of course the entire ECB remain firmly opposed to this idea. But it is probably being implemented in Japan, and I have been surprised (and worried) at the willingness of mainstream central bankers in the US and the UK to contemplate the option in private. This blog serves as a reminder of the serious dangers involved. Read more
Professor Jeremy Stein is a much respected financial economist from Harvard who in May became a member of the board of governors at the Federal Reserve. Until last week, the markets had paid him relatively little attention, but that is now destined to change. The important speech he delivered in St Louis on Thursday about credit bubbles differed significantly from one of the main planks in the Bernanke/Greenspan doctrine of the past 15 years. It does not have immediate policy implications, but it could easily do so within two years.
The speech, which is nicely summarised here by Matthew Klein at The Economist, deserves to be read in full by all market participants. (One member of the FOMC told me last week that the speech was “geeky”, but that was intended, and taken, as a high compliment!)
In summary, the speech argues that the credit markets have recently been “reaching for yield”, much as they did prior to the financial crash. Although not yet as dangerous as in the period from 2004-2007, this behaviour is shown by the rapid expansion of the junk bond market, flows into high-yield mutual funds and real estate investment trusts and the duration of bond portfolios held by banks.
Governor Stein suggests (hypothetically) that this may become a policy headache within 18 months and, in a break with the Bernanke/Greenspan doctrine, he indicates that the right weapon to deal with this might well be to raise interest rates, rather than relying solely on regulatory and other prudential policy to control the process. This would obviously come as a big surprise to the markets, which have tended to view the Fed’s stated concerns about the “costs of QE” as so much hot air. Read more
Following today’s glut of monetary policy news, markets seem to have temporarily re-assessed their recent bullishness about the euro. However, investors should not lose sight of the fundamental gap that still exists between the ECB’s preference for relatively traditional monetary policy and the aggressively unconventional approach of the other major central banks. That has not gone away.
For example, the Bank of England remains in unorthodox monetary territory, as shown by its willingness to accept, for the first time, that inflation will remain above 2 per cent well beyond the two-year policy horizon. Mark Carney’s Select Committee evidence may have dashed expectations of a nominal GDP target, and he may have sounded lukewarm about more quantitative easing, but overall he remained extremely dovish, especially with regard to Fed-style forward policy guidance. Read more
Worries about global currency wars have resurfaced in recent weeks, mainly because of Japanese action on the yen. This is only the latest of several such flare-ups since the 2008 financial crash. It is hard to avoid the suspicion that the unconventional monetary policies of the US, UK and others are designed to drive down their exchange rates in order to indulge in “beggar thy neighbour” policies of the type which Samuel Brittan has condemned.
Currency wars strike dread into the hearts of most economists because they contributed greatly to the severity of the Great Depression in the 1930s, especially in the worst phase from 1931-33. The damage done to global trade in that period took several decades to repair, and a repeat of this nightmare cannot be entirely ruled out. However, there are very large differences between the policies pursued in the 1930s and what is happening now, and the results may also be very different. Read more
The decline of 0.1 per cent in US real GDP in 2012 Q4 (at a seasonally adjusted annualised rate) is a definite negative surprise for financial market sentiment, which has become very complacent about the ability of the US economy to withstand the fiscal tightening due to hit the economy.
Fortunately, the underlying picture for final domestic demand is reassuring, which is why the markets have taken these figures in their stride. Today’s figures are unlikely to signal a serious downturn.
But the US economy almost never posts a negative quarter in the middle of a robust upswing, so the figures should give us some pause for thought. Furthermore, the weakness of exports, which is more than a one quarter phenomenon, shows that the global economy had become dangerously dependent on the strength of the US consumer towards the end of last year. Read more
Gavyn Davies is a macroeconomist who is now chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners. He was the head of the global economics department at Goldman Sachs from 1987-2001, and was chairman of the BBC from 2001-2004.
He has also served as an economic policy adviser in No 10 Downing Street, an external adviser to the British Treasury, and as a visiting professor at the London School of Economics.
Gavyn Davies is an active investor and may have financial interests and holdings in any of the topics about which he writes. The views expressed are solely those of Mr Davies and in no way reflect the views of Prisma Capital Partners LP, Fulcrum Asset Management LLP, their respective affiliates or representatives. This material is not intended to provide, and should not be relied upon for, investment advice or recommendations. Readers are urged to seek professional advice before making any investments.