Since 2008 – 2009, exceptional monetary policies have been shoring up economies with abundant liquidity and very low interest rates.
The intention was to ward off imminent defl ation but this approach is now less and less justifi fi ed: the economic recovery is almost 2 years old, fi nancial mechanisms are more or less back to normal and the threat of defl ation has waned. When and how should this policy been abandoned?…..
Edmond de Rothschild Group (Market Outlook: 19/05/2011)
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In the emerging zone, which was the fi rst to benefi t from the global economic recovery and which is the most sensitive to rising commodity prices, central banks started to raise rates at the beginning of 2010 (Malaysia and India in March) and mop up liquidity by increasing minimum capital requirements for banks (China, January 2010). Due to persistent infl ation and a new credit cycle, China, Brazil, Malaysia and Chile have continued to act until recently but real interest rates are still negative in most countries.
HOW WILL THE DEVELOPED WORLD RETURN TO MONETARY NEUTRALITY?
The process is underway
A number of central banks in developed countries have already started out on the road to normalisation. Monetary authorities in countries which were the fi rst to emerge from recession very quickly announced their intention of redirecting monetary policy. Australia and then Norway were the fi rst to move in October 2009 followed by Canada. All three had benefi ted from their mining or oil resources. Sweden is not a commodity producer but the country followed suit in July 2010.
This was because the global economic recovery had rapidly benefi ted the country’s export sectors and growth and the Riksbank felt obliged to act. Interest rates have nevertheless remained moderate overall, between 1% and 2.25% (Norway); only the Reserve Bank of Australia has gone further (4.75%). Financial conditions in these countries are far from restrictive but they are approaching a neutral stance.
Major central banks are facing increasingly asymmetrical risk
The issue concerns how fast other central banks will raise rates rather than the actual directionof the trend. Central bank mandates are not exactly the same from one country to another: national history, culture and politics can lead to different mission statements. The best illustration is the difference between the US Federal Reserve and the European Central Bank. The Fed has a dual role to defend jobs and price stability. The ECB’s stance has been shaped by the Bundesbank and it seeks above all to protect Europe’s single currency.
Over and above these differences, a central bank has a fundamental objective of preserving currency stability by avoiding any infl ation-induced depreciation. Its directors theoretically try to respect orthodox monetary principles.
The emergency situation in 2008-2009 required an unconventional policy response. But is that true today? Central bank balance sheets are still swollen after measures were introduced to shore up sovereign debt and ensure bank liquidity. This is an aberration and measures must now be taken to address the problem. The risk of infl ation from these emergency policies has been the subject of intense debate over recent months and the current situation clearly supports those who recommend an ending such a non-conventional approach.
2011: A TURNING POINT?
The situation has not entirely been cleaned up but a good deal of progress has been made as far as fi nancial mechanisms and bank balance sheets are concerned; Central banks are clearly right to view recent trends as positive. The real question is what happens next. As the economic cycle grows in strength, central banks will have to review policy.
Red lights are fl ashing on commodity prices
Central banks are now preoccupied with when, and how radically, they should adapt current policy. All commodity prices have risen sharply in the last year, whether metals, agricultural products and energy.
Although retail prices are only rising moderately, there is clearly tension further upstream at the industrial level. Producer prices are rising faster across the board and this has already started to feed through to retail price indices. In the euro zone, for example, prices have risen by an annualised 2.8% and by 1.6% excluding food and energy. In the US, overall consumer prices in April had risen 3.2% over a year and by 1.3% excluding food and energy.
Prices are not the only factor weighing on policy changes in central banks. The real economy – business conditions and jobsis recovering. The pace of improvement varies, particularly for jobs, but the cyclical momentum is clear. The state of the banking sector is another key factor to be taken into consideration when defi ning monetary policy. Banks have their own regulator but every central bank naturally has its say. According to the FDIC, US banks have made good progress in cleaning up balance sheets even if the mortgage sector still represents a threat. Banks have been successfully recapitalised and capital ratios in large institutions are returning to normal. The situation is more varied in Europe: many banks are now on a sounder footing but there are still quite a few, in Spain and Germany for example, which remain dependent on central bank aid.
The last important indication comes from bank lending which is recovering everywhere, a sign that banks are returning to their core business and that demand is also back. In the US, corporate loans have been rising since the summer and household borrowing is stabilising. In the euro zone, household loans have been rising for several quarters, including mortgages, and companies have also recently started to borrow more. However, the most signifi cant monetary aggregates such as M2 have only been edging up. The ECB has been quite clear on the need to act against inflationary
threats. The bank is most worried that second-round infl ation might turn a transitory effect into something altogether more permanent. That would disrupt infl ation expectations or “infl ation anchoring” as Jean-Claude Trichet puts it, and encourage economic agents to raise prices.
Wage rises are still very moderate but the ECB’s mission is to take all factors into consideration and move well before risks materialise. It must look at the varied situation in Europe but its fi rst step towards a neutral monetary stance has not been a very big one even if it is signifi cant of things to come. The banks might also be trying to keep long term interest rates under control.
The Fed has a different approach and is no doubt prepared to take the risk of slightly higher infl ation if that means stronger growth. Over and above short term rates which are hovering around zero, the Fed is more interventionist than the ECB both in size and scope. Witness a USD 600bn monetary stimulus programme devoted to purchases of US treasuries up to June 30 2001. Returning to monetary neutrality will be easier for the ECB than the FED. The ECB has also waded into the sovereign bond market but only to the tune of EUR 80bn. And it also neutralised the impact by mopping up bank liquidity, therefore avoiding US-style monetary stumulus.
POSSIBLE SOLUTIONS
Short term interest rates
When, and by how much, central banks will raise rates is still an open question. The ECB has to take troubled peripheral countries into account but it still respected its principles and raised its benchmark rate by 25bp to 1.25% on April 7. The same day, Denmark raised its rates by 25bp to 1.3% but the Bank of England chose to stick at 0.5%. Faced with the exceptional aftermath of the earthquake in March, the Bank of Japan will maintain low interest rates (0.1%) and continue to intervene on government bond markets.
In the US, the Fed has kept federal funds at 0-0.25% since 2008 and its sensitivity to growth and unemployment suggests it will not move to raise rates before 2012 even it traditionally it has always been the fi rst bank to act.
The Fed expects the jobs situation to improve very slowly so its current approach could well persist over several quarters.
Liquidity
Various measures to shore up bank liquidity featured strongly in central bank action during the crisis. They helped banks weather turbulence by supplying liquidityon interbank markets, especially when they froze up after Lehman Brothers collapsed in September 2008. In coming quarters, central banks will have to gradually mop up what has, apart from troubled Irish banks and Spanish savings banks, become surplus liquidity.
The impact of this liquidity can still be seen in expanded central bank balance sheets. In the US, some measures have been abandoned as they no longer serve a purpose but it is the overall mechanism which needs to be revised. Assets held by the Fed have tripled since the beginning of the crisis. After completing its purchases of US treasuries, the Fed will have to decide how to manage fund fl ows (coupons, refunds) from a USD 2.6 trillion portfolio which includes mortgage-backed securities bought in 2010. Above all, the Fed will have to reduce this portfolio by selling the bonds it holds.
As well as selling securities, central banks have a range of instruments that can be used to retire surplus liquidity The only question is how fast they do this. The Fed, for example, has announced it intends to conduct reverse repos with banks. The ECB can only deal very gradually with European liquidity by continuing to provide direct support for institutions which have no direct access to the interbank market.
How far will central banks go?
The ECB was the fi rst to act but has not revealed what its future decisions might be. The current refi nancing rate of 1.25% in the euro zone is objectively a long way from being restrictive and a neutral stance will only be reached at 2%. The ECB’s fi rst move will not have much impact on troubled peripheral countries. The bank is using 12-month moving price rises as a reference. The spread between infl ation and the benchmark rate is around 200bp on average. During the last cycle, the ECB gradually raised its rates from November 2005 –they had been at 2% since June 2003- and reached 4% in June 2007. The last 25bp hike occurred in the summer of 2008. During the 1990s cycle, the Bundesbank peaked at 4.75% when annualised infl ation was running at a maximum of 3.1% (2.6% excluding food and energy).
The Bank of England is facing a more diffi cult situation arising from contradictory trends. Austerity measures are weighing on growth but infl ation is running at 4% due to fi scal measures such as VAT and higher costs fuelled by sterling’s depreciation. The bank will be forced to react soon The Fed’s analysis is based on a very slow recovery in jobs and it takes the view that rising commodity prices are not set to last.
This suggests no imminent rate hikes. This view is however not unanimous among FOMC members. Differences of opinion among committee members will probably widen as the US recovers and the problem of the budget defi cit remains. Any progress in this area looks limited and if no efforts are made to neutralise the Fed’s policy, there could be serious consequences for prices.
CONCLUSION: WHAT COULD GO WRONG
During the 2003-2007 cycle, the Fed was slow to act to the property bubble and its underlying fi nancing so there is some doubt that its current policy is appropriate. Its infl uence on the cost of capital risks distorting prices on certain assets like commodities which have, to a certain degree, become fi nancial assets over the last few years. In contrast, the ECB runs the risk of acting too quickly and jeopardising European growth which is already hampered by ongoing efforts at budgetary discipline and with more to come.
All these contradictions make it tricky to defi ne monetary policy for the coming quarters. If energy prices continue to rise, household disposable income will suffer; central banks will have to take account of that in their moves towards monetary normalisation.
Deleveraging by governments and consumers is also relevant to central bank analysis as it represents a lasting brake on growth. Central banks in the emerging zone are also faced with contradictions, most notably interest rates versus currency levels.
Their success of failure, with China leading the way, will impact monetary policy in the G4 group of countries. But the skill shown by monetary authorities in emerging countries since the beginning of the crisis is a point in their favour and represents an advantage for the global economy.
Source: BONDWorld – Edmond de Rothschild Group (Market Outlook: 19/05/2011)
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