After more than 20 years, and 82 issues, Sir Mervyn King has delivered his last Inflation Report. The transparency and rationality of this innovation has been one of Britain’s most important gifts to the world in recent times, even if the UK has not actually been very good at controlling inflation itself since 2008. As its main architect and, in his own words, the UK’s “consistent monetary referee”, Sir Mervyn deserves great credit. I hope that, in retirement, he will receive it.
The economic message of today’s report is a familiar one. Inflation has been revised down so that it is shown to hit the 2 per cent target in two years’ time, and real GDP is forecast to recover gradually. Similar forecasts have proven too optimistic in the past, but this time there are clear indications that the Bank will be introducing new forms of policy easing in the next few months, which may underpin the economic recovery.
Following the astonishing arrival of Governor Kuroda in Japan, Mr Carney must be sorely tempted to follow suit in trying to jolt UK economic expectations towards a new equilibrium. He is likely to get plenty of encouragement in this from the chancellor, who emphasised in the Budget that “monetary activism” is a core part of his overall economic strategy.
In fact, Mr Osborne has asked the Bank to focus in the August Inflation Report on how the UK might adopt forward policy guidance, with thresholds, following the example of what the Fed did (successfully) last December. This is an unusually specific request from the Treasury, and even Sir Mervyn seemed sympathetic to this approach today.
In the context of high British inflation, there are serious impediments to repeating the fireworks unleashed by the BoJ, but some progress can be made, Fed-style. What exactly can we expect? Read more
The Federal Reserve will be at the centre of market attention this week with a collection of FOMC speeches, culminating with Chairman Bernanke on “economic prospects for the long run” next Saturday. The Chairman made headlines on Friday when he said that the Fed is now watching “particularly closely” for instances of “reaching for yield” and other forms of excessive risk taking, but there was no smoking gun suggesting that this enhanced monitoring by the Fed would lead to any early amendment to the pace of asset purchases or the level of interest rates. Regulatory controls look much more likely.
On the wider issue of general monetary policy, the behaviour of inflation and unemployment remain the key drivers, and here the Fed has a headache. Its forward guidance on unemployment is in danger of giving misleading signals about the need for tightening, and it probably needs to be changed. Read more
Martin Wolf’s column on Wednesday and his subsequent blogpost have once again focused attention on the importance of trade flows in the eurozone. Martin’s argument is that the German strategy of fiscal austerity and internal reform to fix the imbalances needs to change. I would like to ask a different question, which is what happens in the likely event that it does not change?
Investors, ever more optimistic that the worst of the euro crisis is over, are asking whether the German strategy might actually work. Largely unnoticed by some, eurozone trade imbalances have in fact improved dramatically in recent years. But this has happened mainly for the wrong reasons, ie recession in the south rather than any large narrowing in the competitiveness gap. The eurozone is engaged in a race between the gradual pace of internal devaluation and the mercurial nature of democratic politics. It is still not obvious how this race will end.
When the euro was launched in 1999, its supporters believed that the balance of payments crises which had plagued its weaker members for decades would become a relic of the past. The crisis revealed this view to be entirely complacent. The current account imbalances which were generated by the peripheral economies during the boom of the 2000s soon became impossible to finance after the crash. It was only the growth of so-called “Target2″ imbalances on the ECB’s balance sheet which provided the official financing which held the system together. No Target2, no euro.
However, some of the contingent credits which the Bundesbank has acquired against the rest of the ECB in the course of this process might become worthless under certain break-up scenarios, and this has become a political hot potato inside Germany. The solution, many in Germany believe, is to foster an improvement in the balance of payments positions of the troubled economies so that no further rise in the Target2 imbalances will be needed. Read more
In the past few weeks, a puzzle has developed in the global financial markets. Equities, at least in the developed countries, have broken free of the constraints which normally bind them to fluctuations in the global economy. To misquote the old Heineken advert on British television, the central banks have refreshed the parts which other factors cannot reach. Inflection points in QE are all that seem to matter and there is barely an equity bear left in the investor community.
Of course, there are always a few exceptions which prove the rule. Albert Edwards, the markets’ favourite bear at Société Générale, wrote last week:
The intoxicating potency of QE has drugged investors into believing they must participate in this liquidity fuelled frenzy. I repeat my thoughts of 2007… this liquidity argument is merely “lies, rhubarb, poppycock, bilge and utter nonsense”…The unfolding recession accompanied by full-blown deflation will result in a loss of investor confidence so that central banks are unable to prevent a Japanese-style deflationary event. The equity market will riot, Japan-style.
Who knows, Albert’s bearishness may be justified in the very long run. But for now the bulls are in the ascendancy. The reach for yield is extending into the equity market, and it will probably continue to do so unless the latest mini downcycle in global activity develops into something more serious. Read more
Market expectations about Thursday’s ECB meeting had become quite bullish in the past couple of weeks (see this blog), and Mr Draghi went just far enough to justify those expectations by cutting the main repo rate by 0.25 per cent and the marginal lending rate by 0.5 per cent. This is a clever way of directing more help to those banks which need it most in the south.
Adding to his dovish tone, he talked about cutting deposit rates at the ECB into negative territory, as Denmark has already done (with moderate success), and he hinted that the ECB still has one further repo rate cut in the locker. At the less dovish end of the spectrum, he said that the ECB will not buy government bonds, which does not sound promising for Fed-style QE, should the eurozone economy continue to weaken. Read more
The recent rise in eurozone equities, along with a sharp further decline in peripheral bond spreads, has occurred in the face of continuing disappointing data on economic activity. Real GDP in the eurozone seems to be declining at a 2 per cent annualised rate in the current quarter, and the pivotal German economy is showing worrying signs of being dragged into the mire with the troubled south (see this earlier blog).
Markets are in one of those periods (which usually prove temporary) where they interpret bad economic news as being good news for asset prices, because weaker growth will result in easier policy from the central banks. In the eurozone, expectations are high that the European Central Bank will deliver lower interest rates on Thursday, and specific measures designed to address the provision of liquidity to small and medium sized enterprises (SMEs) in the south seem probable.
But a more radical easing in monetary conditions may prove necessary to drag the economy out of recession, and prevent inflation from falling further below the target, which is defined as “below but close to 2 per cent”. In March, the ECB staff forecast for inflation in 2014 was 0.6-2.0 per cent, which seems barely consistent with the mandate, especially as the recession shows no sign of ending and fiscal policy is still being tightened. Any other major central bank would be urgently reviewing its options for aggressive easing, and the markets could become very disillusioned if they sense that the ECB is unwilling to do the same.
So what, realistically, can the ECB do? The following table gives a fairly comprehensive list of the options which are definitely available within the mandate [A], those which might be available if the ECB chose to interpret its mandate more widely [B], and those which are clearly unavailable under any circumstances [C]:
The new Funding for Lending Scheme (FLS) announced today in the UK is a useful and sensible development. It directly attacks the important micro problem of inadequate lending to small and medium sized enterprises (SMEs). But it is unlikely to have large scale macro-economic effects.
The FLS was introduced last July to address the increase in the funding costs which British banks were incurring as a result of spill-overs from the eurozone crisis. This had increased lending rates on UK mortgages and corporate loans at a time when the monetary policy committee was trying very hard to ease overall monetary conditions in the UK. And the FLS was the chancellor’s main response last year to the charge that he was deaf to the needs of the real economy, and inflexible in his pursuit of austerity policies.
Almost a year later, the verdict on the FLS is that it has significantly reduced banks’ funding costs, with the benefits of that being mostly passed on to mortgage and company borrowers, but that it has had relatively little effect on overall bank lending to companies, especially to small and medium sized enterprises (SMEs).
Today’s extension to the FLS greatly increases the incentive for banks to skew their lending to SMEs by offering them larger overall access to subsidised funding if they do that. Every pound of SME lending in 2013 will contribute tenfold to the banks’ eligible total of subsidised FLS lending. In 2014, it will contribute fivefold.
Furthermore, today’s announcement extends the FLS by 12 months to the start of 2015, thus re-assuring banks that their access to cheap funding for new lending will not suddenly disappear early next year. The Chancellor also hopes that the new FLS will help to influence the IMF’s response to his overall economic approach when they visit the UK shortly. Read more
This week’s IMF meetings in Washington lacked the sense of crisis which has characterised many such meetings since the crash in 2008. Although the official IMF growth forecasts were revised down slightly for 2013, mainly due to tighter fiscal policy in the US, the organisation also said that downside risks, relative to the central forecasts, had diminished since the October 2012 meetings.
These improved downside risks seem to have stemmed mainly from greater confidence in the financial system, reflecting the budget deal on the US fiscal cliff, and the actions of the ECB to reduce systemic threats to the euro. Global equity markets agree with this: they are up by 13 per cent since last autumn.
There is, however, a dangerous schism between the improvements in financial confidence and the marked lack of improvement in global GDP growth. On this latter problem, the Washington meetings were focused mainly on the weakness of the eurozone, with Christine Lagarde calling for “more investment” in Germany, greater steps towards banking union and bank recapitalisation, and ECB measures to deal with fragmentation in monetary conditions between the core and the periphery. The G20 statement refrained from setting any targets for public debt reduction, which suggests that Keynesian thinking is gaining ground in international policy circles.
The IMF and the US administration are as one on all this, but my impression is (confirmed here by Chris Giles) is that the gap between Washington and Berlin is wider than ever, especially on fiscal stimulus in Germany. There is a marked sense of frustration, but also of resignation, in Washington about the German approach. Plus ça change. Read more
The work of Carmen Reinhart and Ken Rogoff (RR) on public sector debt ratios, and their relationship with GDP growth, has been extraordinarily influential in academic and policy circles since 2010. Before this week, their statistical analysis, based on a 200-year database which they had painstakingly assembled covering dozens of countries, had appeared to establish an important stylised fact: that debt ratios above 90 per cent were associated with much lower rates of GDP growth than debt ratios under 90 per cent. The sudden drop in growth at a debt ratio similar to that reached in many developed economies acted as a wake up call to governments and encouraged the adoption of austerity programmes.
This week, a paper by Thomas Herndon, Michael Ash and Robert Pollin (HAP) argued that the RR stylised fact was based on simple statistical errors, including a spreadsheet error which RR have now acknowledged. Their critique of the original RR stylised fact promises to establish an alternative conventional wisdom, which is that high public debt ratios are never damaging for GDP growth. But the truth is more complicated than that, and far less certain. Read more
The IMF on Tuesday repeated its call for the ECB to reduce policy rates in the eurozone, and Mario Draghi came fairly close to promising action in May at his press conference after the governing council meeting on April 4. But no-one really believes that the expected 0.25 percentage point cut in the main refinancing rate will do very much to solve the eurozone’s most pressing problem, which is the lack of bank lending to small and medium sized enterprises (SMEs) in the troubled economies.
Monetary conditions in the eurozone are fragmented. Bank lending rates are, perversely, much higher in the weakest economies than they are in the core. Unless this is solved, the eurozone economy will remain in trouble.
In order to address this issue, the ECB needs to think in ways which are unconventional, and therefore unpalatable for many of the conservatives on the governing council. However, both Mario Draghi and his colleague Benoît Cœuré have recently hinted that they view measures to eliminate fragmented lending rates as essential to fulfil the mandate of the ECB. This is how they justified the introduction of the Outright Monetary Transactions (OMT) programme, which saved the euro last autumn.
They have also said that the power of the ECB in this area is limited, and have argued repeatedly that effective action will require co-operation from member governments and from the European Investment Bank (EIB). It is therefore probable that discussions are under way between the ECB and member states to decide what can be done. There are two options which could have significant beneficial effects. Read more