Mervyn King. Image by Getty.
A few weeks ago, the big central banks were calmly embarking on their “exit” strategies from unconventional monetary accommodation. Then the global economy slowed but for a while inflation remained too high for the Fed or the ECB to consider further easing. Their hands were tied until inflation peaked. Recognising this, markets collapsed. But now that there are some tentative signs of inflation subsiding, the central banks are rediscovering their ammunition stores.
There are basically three types of action that they are considering. In order of orthodoxy, and stealing some of Mervyn King’s terminology, here is a taxonomy of possible measures:
1. Conventional liquidity injections
This is safe territory for the central banks, and they are willing to act swiftly and decisively if necessary. Yesterday’s injections of dollar liquidity into the European financial system are a case in point. Some European banks, especially those in France, were finding it very difficult to raise dollar financing, which they needed in order to pay down earlier dollar borrowings, and to make loans to customers in dollars. The resulting strains in the money markets were undermining confidence in the ability of these banks to remain liquid, and markets were increasingly unwilling to accept their credit. This presented a classic case for the ECB to inject liquidity, using conventional currency swap arrangements to raise dollars from the Fed. Although the ECB will incur a minimal amount of currency risk in the process, and will also incur some credit risk (which will be collateralised), this is very much business as usual for any central bank, as it was in 2008. Read more
The key focus of the coming week in financial markets will be the speech of Fed chairman Ben Bernanke at the Jackson Hole conference on Friday. Last year, the same speech was taken as confirmation that the Fed intended to embark on QE2, and this eventually triggered a 30 per cent rise in risk assets over the next six months. With the economy still weakening, the Fed is once again in easing mode, and some in the markets are hoping for another full dose of QE. They are likely to get something rather different. 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
Ben Bernanke. Image by EPA.
The financial markets seem determined to interpret today’s statement by the Fed chairman in a dovish light, but a careful reading of his words does not support that point of view. True, Mr Bernanke outlined the possible ways in which monetary policy might be eased further if recent economic weakness should prove more persistent than expected. But he gave equal weight to the possibility that “the economy could evolve in a way that would warrant less-accommodative policy”.
There was no hint in the text about which of these outcomes he considered the more likely. We already knew from yesterday’s FOMC minutes for the June meeting that the committee is split about the likely evolution of policy, and we were waiting to see today whether the chairman would throw his weight behind either the doves or the hawks. He failed to do either. Read more
Risk assets like global equities have had a very bad day, but they are still trading fairly close to their highs for the year. This is surprising, given the continuing slowdown in the global economy, and the failure of policy makers in Europe and the US to come to terms with the serious problems facing them.
Particularly worrying is the growing evidence that the US economy is struggling even to hold unemployment constant, while fiscal and monetary policy have both become moribund for the time being. The markets still seem confident that US growth will spontaneously reignite in coming months, without requiring any help from expansionary policy. If they are wrong, there are few signs that US policy would be able to respond quickly or coherently. Read more
The ongoing discussions in Washington about the US public debt ceiling are raising some interesting ideas, some of which are highly unorthodox. One such idea is that the debt ceiling itself can simply be ignored because any attempt by Congress to restrict the ability of the United States to meet its debts appears, on the surface, to contravene section four of Amendment XIV of the Constitution.
This Amendment states that “The validity of the public debt…shall not be questioned.” I will leave this matter for debate among constitutional lawyers (see here and here), but as a simple economist I would question whether the US would retain its triple A status if the administration continued to make payments in contravention of an explicit act of Congress, which the President believed to be unconstitutional. What would happen to the “full faith and credit” of the United States if the Supreme Court subsequently ruled that the President was wrong? Read more
The US employment numbers for May seemed to surprise the markets, but in fact they confirmed what we already knew from a string of earlier data releases, which is that the economy has slowed very markedly in recent months. The debate now is whether this slowdown has been triggered mainly by transitory factors – the fallout from the Japanese earthquake, stormy weather, and a spike in gasoline prices above $4/gallon – or whether it reflects a more fundamental malaise in the economic recovery.
The equity markets have remained fairly upbeat about this, and most economists are still strongly of the view that this is just another mid-cycle slowdown of the sort which occurred last year. This still seems to be the most probable outcome (as I will argue here on Sunday). But what if this optimism is wrong? Is there a Plan B? Read more
Following yesterday’s live blog on FT Alphaville, here are some quick final reflections on the Bernanke press conference: Read more
In preparation for Chairman Bernanke’s press conference on Wednesday, my friends at FT Alphaville asked me to respond to a series of questions on US monetary policy – first predicting what the Fed Chairman will say, and then commenting on what he should say. During the press conference itself, I will be participating in a live blog session over at Alphaville. Read more
The past week has seen new highs for the year in many major equity markets, including the US. However, oil prices have continued to climb in ominous fashion, and there have been some weaker signals from the initial economic activity indicators which have appeared for the month of April. In the US, for example, the important Philadelphia Fed index fell sharply, housing data continued to bump along the bottom, and initial unemployment claims were disappointing. Next Thursday will see the publication of the US GDP figures for 2011 Q1, which are likely to report quarterly annualised growth at only around 1.5 per cent, sharply down from the previous quarter. So why has the US economy slowed, and should we be worried about it? Read more
Many investors fear that the Fed’s impending exit from QE2 will have a very damaging effect on the financial markets. Whether they are right will depend on the nature of the exit, and its impact on bond yields. Read more
The financial markets remain torn between their concerns over “black swans” (exogenous shocks from oil prices, food prices, and the Japanese earthquake) and the improving state of the global economy. Read more
The behaviour of the world’s two main central banks, and the relationship between them, have profound effects on global financial markets. As a broad rule of thumb, the ECB (and the Bundesbank before it) have tended to act in a very similar manner to the Fed, except about 6-12 months later. In fact, that is one of the most well established rules in the analysis of monetary policy making.
It does not imply that the ECB deliberately “copies” the Fed, which it clearly does not do. But it does imply that circumstances have usually produced this symbiotic relationship between the two key central banks. When this relationship has been broken in the past, it has usually spelled trouble. Read more
The combination of a rapidly growing economy, and a surge in oil prices, has raised questions about the strength of the doves’ hand at the Fed. Previously in firm control, the doves had until yesterday been silent about the recent mixture of strong GDP growth and rising headline inflation. Was the case for exceptionally easy monetary policy beginning to fray at the edges? Not in the mind of New York Fed President Bill Dudley, who is among the most eloquent spokespersons for the dovish standpoint. Read more
This week, the dramatic events in Egypt failed to unsettle the global financial markets. Not only do investors believe that Egypt itself is not critical for global oil prices, they also seem to believe that there will be relatively little contagion to the more important oil producing states elsewhere in the Middle East. Read more
The era in which central bankers could apparently do no wrong ended emphatically in 2008. Since then, they have attracted plenty of criticism as they have adopted a succession of unconventional policies to stabilise the world economy and financial system. Read more
The batch of new year forecasts for the world economy have been almost uniformly positive this year, at least from economists in the financial markets. Only a few months ago, forecasters were talking of increasing risks of a double dip recession, but the surge in risk assets since the Federal Reserve announced QE2 in the autumn has swept away most of this pessimism. JP Morgan this week said simply that “strong global growth is baked in the cake”. Although nothing in economic forecasting is that certain, there is plenty of evidence in favour of the recent outbreak of optimism.
First, the most reliable and timely indicators of global economic activity have recovered strongly in recent months. Although QE2 may have helped somewhat in this regard, it is much more likely that the pause in the global economy was anyway about to end when the Fed took its expansionary decisions in the early autumn. Read more
Both the Federal Reserve and the ECB are now purchasing government debt in large scale. Yet neither of them seems at all eager to admit that they are doing anything unconventional with their monetary policy. In fact, some of the recent statements by both Ben Bernanke and Jean-Claude Trichet are not as straightforward and transparent as they might have been. Read more
Today’s publication of the latest FOMC minutes will probably unveil significant downward revisions to the Committee’s inflation and gross domestic product forecasts for 2011, as well as a large upward revision to its unemployment forecast. More interestingly, the minutes will show whether the FOMC is broadly united on the strategy of quantitative easing which it has now adopted. Read more