Monetary policy

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]:

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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

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. Read more

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 wayRead more

It is often claimed by economists that the central banks have run out ammunition to boost economic activity, but they certainly have not lost the ability to have an impact asset prices. Since the latest round of quantitative easing was signalled back in June (see this blog), global equity prices have risen by 14.5 per cent, and commodity prices are up by 15.4 per cent, despite the fact that economic activity data have shown no improvement whatever over this period.

Clearly, these impressive moves in asset prices have been triggered by a sharp decline in the disaster premia that were priced into markets only three months ago. Mario Draghi and Ben Bernanke have, in a sense, purchased global put options on risk assets, and have offered them without charge to the investing community.

By doing the market’s hedging for it, the central bankers have certainly had an impact. Confidence, while not fully restored, is much improved, which is exactly what was intended. But there is no sign yet from hard data that the downward slide in global GDP growth has been reversed. Until that happens, the market rally will remain on insecure foundations. Read more

The fall in US unemployment remains slow but with no clear deflationary threat the US Federal Reserve is in a quandary regarding the next steps in its monetary policy. John Authers, Long View columnist, asks Gavyn Davies, chairman of Fulcrum Asset Management, what Ben Bernanke, chairman of the Fed, is most likely to do next.

The minutes of the Fed’s FOMC meeting on 18th and 19th June were published on Wednesday, but the markets remain confused and divided about the central bank’s true intentions on the stance of monetary policy. Surveys of market participants show that they are almost evenly split between those who expect QE3 to come this year, and those who do not. And usually highly informed commentators have differed sharply about the hidden meaning in this set of minutes.

Robin Harding of the FT concluded that the tone was dovish, heralding the likely arrival of QE3 if the economy remains weak. Tim Duy, in his excellent Fed watch blog, says that Ben Bernanke is sceptical about the efficacy of a further increase in the balance sheet, and is looking for different options to ease. That could take a while. Jon Hilsenrath at the Wall Street Journal said that the Fed is in a state of “high alert” about the economy, but has not yet decided to pull the trigger, partly because “many Fed officials are uncomfortable with the mix of unconventional tools that they have to address the soft economy”. In particular, there are growing concerns that further purchases of treasury securities will damage the workings of the market in government debt. The Fed staff has been asked to report back on this in future meetings. Read more

As the eurozone crisis enters a critical phase, market attention is once more focused on the central banks to contain the crisis. They have promised in advance to provide unlimited liquidity to solvent financial institutions if necessary in coming weeks, which is now their standard response to financial shocks. However, the slowdown in global activity caused by the euro crisis may mean that they are thinking of acting more aggressively than that. A further large bout of unconventional easing is now on the agenda. Read more

Risk assets rose slightly last week, and global equities are still trading within about 2 per cent of their highs for the year. The resilience of equities was slightly surprising in a week which saw both a disappointing set of US GDP data and a Fed policy statement which was on the hawkish side of expectations. Goldman Sachs’ economists commented that the US economy and financial markets are “moving into a tougher environment”, in which the economy is slowing and the Fed is shifting its policy reaction function in a less stimulative direction.

One reason why risk assets have remained firm recently, is that earnings in the latest company reporting season have once again been beating expectations in the US and the eurozone. According to Jan Loeys at JP Morgan, US corporate earnings per share for 2012 Q1 have come in 8 per cent higher than analysts’ expectations, while the drop in eurozone earnings has been 4 per cent less than feared. Clearly, corporate financial strength has been helping investment sentiment, but that would not persist for very long if the Fed really did change its tune on monetary policy. Read more

The minutes of the Federal Open Market Committee meeting on March 13 have surprised the markets. The committee seems to have shifted in a markedly more hawkish direction than was reflected in the statement issued after the meeting, and the bar to quantitative easing 3 now seems to be rather high. Perhaps we should have expected this, given the fact that speeches by chairman Ben Bernanke and Bill Dudley since the meeting had given no hint of any further easing. But the breadth of the committee’s shift away from easing was certainly not expected.

It is easy to find hawkish phrases in the minutes. The US Federal Reserve staff has not only upgraded its real gross domestic product projections, and increased its inflation forecasts, but has also reduced its estimate of the output gap. Only “a couple” of FOMC members saw any case for further easing, and then only if growth falters or inflation falls below target. There was even some discussion of changing the guidance on keeping short rates “exceptionally low” up to the end of 2014, a move which would really shock markets.  Read more

A large and important change is underway in global economic policy. This change will determine whether the developed economies can grow their way out of recession. Although the new strategy has been tried before by individual economies, this is the first time it has been adopted on such a global scale. If it fails, it is far from clear that policy-makers have a ready-made alternative plan waiting in the wings. Read more

The Bank of England meets on Thursday with expectations running high that the MPC will announce a further large dose of quantitative easing. Even if they pass this month, which seems possible, this is likely to be only a temporary postponement. Whenever it comes, the next move will be another bout of “plain vanilla” QE, involving the purchase of £50-75bn of government bonds, and taking the overall Bank of England holdings to over one third of the total stock of gilts in issue.

Meanwhile, the Fed is still debating whether to increase its holdings of long dated securities, and if so whether to focus once again on government debt, or to re-open its purchases of mortgages. Any further QE would be contentious on the FOMC, but there is probably still a majority in favour.

Central bankers, unlike many others, have not lost faith in the efficacy of QE. The vast majority of them not only believe that additional asset purchases can further reduce long term bond yields at a time of zero short term interest rates, but also that this can increase real GDP growth, compared with what otherwise would have occurred. Are they right? Read more

Mount Fuji, Japan. AFP/Getty Images

Mount Fuji, Japan. AFP/Getty Images

Until recently, Keynes’ notion of a liquidity trap was of great interest to macro-economists, but was viewed by investors as a rare aberration which, outside Japan, could be safely ignored. In the aftermath of the 2008 credit crunch, all that has changed. Many developed economies seem to be falling into a liquidity trap, and may stay there for several years. What does this imply about asset returns? (This blog is a slightly longer version of an article which first appeared in the FT’s Market Insight column on 24 January, 2012.) Read more

Federal Reserve. Getty Images

Getty Images

In 1951, an epic struggle between a US president who stood on the verge of a nuclear war, and a central bank that was seeking to establish its right to set an independent monetary policy, resulted in an improbable victory for the central bank. President Harry Truman, at war in Korea, failed in a brutal attempt to force the Federal Reserve to maintain a 2.5 per cent limit on treasury yields, thus implicitly financing the war effort through monetisation. This victory over fiscal dominance is often seen as the moment when the modern, independent Fed came into existence.

The idea that the central bank should place a cap on the level of bond yields is firmly back on the agenda, at least in the eurozone. This week, Italian prime minister Mario Monti said that he was increasingly optimistic that his country’s bond yields might soon be capped. Although he stopped short of saying that this would be done by the European Central Bank, there really are no other viable candidates to achieve this. Furthermore, many economists are arguing that this is the right policy, since Italy is now following a sustainable budgetary policy which deserves to be rewarded by ECB action in the bond market. Read more

Amid all the focus on the UK’s decision to use its veto, it is important not to miss the main economic outcome of the summit, which is that the agreement heralds a new era in European policymaking. The German approach to fiscal policy will now be writ large across the eurozone. This raises three key questions:

  1. How different will this prove to be in practice from the old status quo?
  2. Is it a good idea from an economic point of view?
  3. Does it allow the European Central Bank in future to play the same role in the eurozone as the Federal Reserve and the Bank of England have been playing in the US and the UK?

My initial take on the deal is that it will be sufficient to dampen the acute phase of the crisis, but that the absence of a clear long-term strategy for growth means that there could still be a long period of chronic problems ahead. Read more

Mario Draghi

Mario Draghi — Getty Images

In Mario Draghi’s first meeting as the new president of the ECB on Thursday, he already faces a decision which could determine the eventual fate of the euro. This is not a decision about whether to cut short term interest rates. They will be cut, decisively, before the year end. Nor is it a decision about the maintenance of non-standard measures to inject liquidity into the eurozone’s banking sector. These measures will be maintained and increased.

Instead, his historic decision will be whether to use the balance sheet of the central bank to purchase the troubled debt of countries like Italy and Spain, and thus effect a large transfer of resources between the member states of the eurozone – a transfer which the political leaders of the zone have so far been unable to undertake. It is becoming increasingly clear that, among European institutions, only the ECB has the constitutional authority and the financial muscle to undertake such a transfer. But is it appropriate territory for a central bank to enter? That is President Draghi’s dilemma. Read more

The Fed decision was fairly close to what was anticipated in this earlier blog – all “twist” and no “shout”. However, on balance, the statement was slightly more dovish than I expected. Concerns about downside risks to economic activity were at least as great as in last month’s FOMC statement, with new downside risks from financial strains being specifically mentioned, and this has swayed the majority of the committee to introduce a slightly more aggressive operation “twist” than expected. Inflation concerns, while marginally greater than in the August FOMC statement, are clearly insufficient to impress the committee, which remains biased towards further easing even after today’s announcement.

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The decision of the Swiss National Bank to set a limit on the strength of the Swiss franc so that it cannot trade below a minimum rate of CHF 1.20 against the euro is one of the most dramatic interventions seen in the foreign exchange markets for many years. The Swiss economy may only account for 0.8 per cent of global gross domestic product, but its currency and the influence of its central bank far outweigh its economic size. Read more

Opinion is sharply divided about what the Fed intended to signal in the statement issued on Tuesday. Some have seen the statement as very dovish, because it said that the Fed intended to leave short rates at “exceptionally low levels” until mid 2013 – the first time that a specific date of this sort has ever been set by the FOMC.

Others, however, concluded that the statement contained nothing really new, since the markets had already assumed that short rates would be close to zero for the next two years. Furthermore, the fact that there were three dissents from the majority decision has led some to deduce that the further large step to more quantitative easing (QE3) is still a long way off. On this view, nothing really changed. Read more

The recent fall in equities represents a belated recognition by the markets that the global economy has been much weaker than consensus economic forecasts indicated earlier in the year. Unlike last summer, when the same thing happened, the markets have also begun to recognise that policy makers have little ammunition left in the locker to combat the downturn.

The political will needed to ease fiscal policy, even temporarily, has evaporated on both sides of the Atlantic. And monetary policy has been hamstrung by the rise in inflation, which has clearly changed the thinking of the Fed. So where is the escape route? Read more