Monetary policy

The global markets remained in reflationary mode for much of last week, a regime that has now persisted for many months. Led by the US, bond yields have been rising, mainly because inflation expectations are on the increase. Risk assets have been performing adequately, with the exception of the emerging markets.

This reflationary regime has been driven by much stronger global economic activity since mid-2016, and latterly by a belief that Donald Trump’s election victory will lead to US fiscal easing, along with the possibility of the “politicisation” of the Federal Reserve, implying overly accommodative monetary policy.

There are various ways in which this regime could end. The world economy could suddenly go back to sleep, as it has on many occasions since 2009. The US fiscal easing could become bogged down in the Washington “swamp”. Or the Fed could become unexpectedly hawkish, stamping on the first signs of inflationary growth in the American economy. This last risk is probably under-estimated, and is worth considering in detail. Read more

Hillary Clinton and Donald Trump

Hillary Clinton and Donald Trump  © Getty Images

Presidential elections have often marked major changes in American attitudes towards fiscal policy.

The arrival of President Kennedy in 1960 represented the beginning of Keynesian fiscal activism. President Nixon’s election in 1968 marked the high point of inflationary budgetary policy designed to finance the Vietnam War.

President Clinton in 1992 ushered in a period in which the reduction of public debt was paramount. The elections of President Reagan in 1980, and George W. Bush in 2000, marked eras in which tax cuts took precedence over budget balance, and counter-inflation policy was ceded to the Federal Reserve.

As the 2016 election approaches, investors are wondering whether another major change in the approach to fiscal policy is in the works. Is a lurch towards fiscal stimulus the “next big thing” in Washington? Possibly, but I am not convinced. Read more

Fiscal policy activism is firmly back on the agenda. After several years of deliberate fiscal austerity, designed to bring down budget deficits and stabilise public debt ratios, the fiscal stance in the developed economies became broadly neutral in 2015. There are now signs that it is turning slightly expansionary, with several major governments apparently heeding the calls from Keynesian economists to boost infrastructure expenditure.

This seems an obvious path at a time when governments can finance public investment programmes at less than zero real rates of interest. Even those who believe that government programmes tend to be inefficient and wasteful would have a hard time arguing that the real returns on public transport, housing, health and education are actually negative [1].

With monetary policy apparently reaching its limits in some countries, and deflationary threats still not defeated in Japan and the Eurozone, we are beginning to see the emergence of packages of fiscal stimulus with supply side characteristics, notably in Japan and China.

Investors are asking whether this pivot towards fiscal activism is a reason to become more bullish about equities and more bearish about bonds, on the grounds that the new policy mix will be better for global GDP growth. This is directionally right, but it is important not to exaggerate the extent of the pivot. Read more

The ECB decided yesterday against “going negative” by reducing its deposit rate from zero to -0.25 per cent. The Governing Council again debated the pros and cons of such a measure, which would represent the first time that any of the major four central banks would ever have reduced a key policy rate to below zero [1]. Mr Draghi said again that the ECB was “technically ready” to take this action, and that the option remains “on the shelf”.

Many in the markets believe that this is just a bluff to prevent the euro from rising in the foreign exchange markets. There have been several unsupportive comments from leading members of the Governing Council (Asmussen, Mersch, Noyer and Nowotny) and Mr Draghi admitted that disagreements exist in the Council. Nevertheless, the President has deliberately left the option on the table, so it is important to understand the debate.

The technical aspects of negative rates have been very well covered in FT Alphaville recently, but I would like to focus on the broader policy implications. Why would a central bank want to take this action, and could it back-fire on them? 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