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.
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.
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.
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.
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.
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.
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.
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.