Overview: Monetary Policy Alone Will Not Save the World Economy
By Michael Manetta
Aug 19, 2011 10:51:00 AM | Last Updated
With U.S. growth at stall speed and the eurozone (EZ) crisis deepening, developed market (DM) central bankers are taking a decided turn toward monetary easing in an effort to once again avoid the perils of a debt-deflation cycle.
Aug 19, 2011 10:51:00 AM | Last Updated
With U.S. growth at stall speed and the eurozone (EZ) crisis deepening, developed market (DM) central bankers are taking a decided turn toward monetary easing in an effort to once again avoid the perils of a debt-deflation cycle.
Emerging market (EM) central banks, many of which still face elevated inflation risks at home, will delay or abort tightening cycles but will resist monetary easing in the near term as they balance on the horns of the policy trilemma, seeking to retain export competitiveness without stoking inflation.
Over the medium term, continued balance-sheet stress and fiscal austerity in DMs, as well as an impending growth slowdown in China, will push central banks to find new ways of stimulating demand, likely ending the predominant role of inflation-targeting in the global monetary regime.
Figure 1: DM and EM Growth and Headline Inflation, Weighted by PPP Shares of World GDP (%, y/y)
Source: Haver, IMF, RGE
Source: Haver, IMF, RGE
Since the last Central Bank Watch in June, when we warned of a stalling recovery, the global growth outlook has deteriorated significantly.
This became all the more apparent in light of the U.S.’s downward revision to H1 growth, debt limit (ir)resolution that is likely to exacerbate the fiscal drag on growth and ongoing stress in the labor and housing markets.
The EZ continues to struggle under the weight of its sovereign debt, structural and financial crises, and is now facing a sharp slowdown in economic activity following a subpar Q2. Asian PMIs point to weaker global demand, portending a rough second half for the region’s export-dependent economies. Latin American growth has also slowed, normalizing from unsustainable levels and converging toward potential.
In response, DM central banks have taken a decided turn toward monetary easing. The Reserve Bank of Australia (RBA) opted for a rate pause on August 2, despite a pickup in inflation in Q2. On August 3, the Swiss National Bank (SNB) took a more dramatic approach, announcing a surprise rate cut and “quasi-quantitative easing” operations aimed at stemming the appreciation of the franc. The Bank of Japan (BoJ) quickly followed suit on August 4 with a unilateral intervention in the FX market (in an attempt to weaken the yen) and an extension of its own asset-purchase program, to keep interest rates near zero and ward off deflation. On August 7, the ECB announced an extension of its Securities Markets Program to include purchases of battered Italian and Spanish sovereign debt. On August 9, the U.S. Federal Reserve affirmed that “exceptionally low” rates would continue into mid-2013 (a clear precursor to QE3). A day later, the Bank of England released a dovish inflation report, which we interpreted as heralding an extended rate pause and opening the door to further quantitative easing (QE)—we believe this will come in November. Norway’s central bank on August 10 also opted to stay on hold, despite mentioning a “100% probability” of an impending rate hike in its June Monetary Policy Report.
Figure 2: G4 Policy Rate Expectations
Source: Bloomberg, RGE
Policy Maneuvering and the Trilemma
In response, DM central banks have taken a decided turn toward monetary easing. The Reserve Bank of Australia (RBA) opted for a rate pause on August 2, despite a pickup in inflation in Q2. On August 3, the Swiss National Bank (SNB) took a more dramatic approach, announcing a surprise rate cut and “quasi-quantitative easing” operations aimed at stemming the appreciation of the franc. The Bank of Japan (BoJ) quickly followed suit on August 4 with a unilateral intervention in the FX market (in an attempt to weaken the yen) and an extension of its own asset-purchase program, to keep interest rates near zero and ward off deflation. On August 7, the ECB announced an extension of its Securities Markets Program to include purchases of battered Italian and Spanish sovereign debt. On August 9, the U.S. Federal Reserve affirmed that “exceptionally low” rates would continue into mid-2013 (a clear precursor to QE3). A day later, the Bank of England released a dovish inflation report, which we interpreted as heralding an extended rate pause and opening the door to further quantitative easing (QE)—we believe this will come in November. Norway’s central bank on August 10 also opted to stay on hold, despite mentioning a “100% probability” of an impending rate hike in its June Monetary Policy Report.
Figure 2: G4 Policy Rate Expectations
Source: Bloomberg, RGE
Policy Maneuvering and the Trilemma
The shift toward a looser monetary policy stance in DMs is a clear reversal of the nascent policy normalization that began last year (with hikes by the Bank of Canada, the Swedish Riksbank, the RBA and Norges Bank) and continued into 2011, culminating in ECB rate hikes in April and July (a policy mistake that will have to be undone, in our view), and the expiration of QE2 in the U.S. in June.
Despite recent calls for unity by the G7 and G20, early policy maneuvering suggests a resumption of beggar-thy-neighbor policies, particularly among economies trying to protect export competitiveness.
Indeed, by August 11 the SNB was floating the idea of a peg to the euro, and on August 17 injected another CHF80 billion into the banking system, again trying to weaken the franc. Stuck on the horns of the policy trilemma, the SNB is clearly willing to risk housing and asset price bubbles in the hopes of maintaining export market share in a slower growth environment.
Figure 3: Major DM Currencies and CNY vs. USD Through mid-August 2011 (Jan 2007=100)
Source: Bloomberg
Of course, EMs have also been struggling with the constraints of the trilemma. China is perhaps the most notable example, where the dollar shadowing of the People’s Bank of China clearly has exacerbated domestic inflationary pressure.
Figure 3: Major DM Currencies and CNY vs. USD Through mid-August 2011 (Jan 2007=100)
Source: Bloomberg
Of course, EMs have also been struggling with the constraints of the trilemma. China is perhaps the most notable example, where the dollar shadowing of the People’s Bank of China clearly has exacerbated domestic inflationary pressure.
A number of other EMs have also chosen to resist currency appreciation and interest rate hikes, often relying on macroprudential measures and even punitive taxes to manage liquidity and inflation. This policy combination has led to the de facto adoption of ultra-loose Fed policy in economies growing close to or above potential, resulting in higher inflation.
Figure 4: Valuation-Adjusted FX Reserve Accumulation (12 months to July 2011, USD, billions)
Source: IMF IFS, RGE
Finding the appropriate policy mix is likely to get even more difficult in the coming months. In fact, EMs will face many challenges similar to those of 2009: sluggish external demand, strong capital inflows, upward pressure on currencies and liquidity expansion in domestic financial markets. However, assuming DMs do not fall into recession, low interest rates and a weaker currency may not be a suitable policy option either.
Figure 4: Valuation-Adjusted FX Reserve Accumulation (12 months to July 2011, USD, billions)
Source: IMF IFS, RGE
Finding the appropriate policy mix is likely to get even more difficult in the coming months. In fact, EMs will face many challenges similar to those of 2009: sluggish external demand, strong capital inflows, upward pressure on currencies and liquidity expansion in domestic financial markets. However, assuming DMs do not fall into recession, low interest rates and a weaker currency may not be a suitable policy option either.
Unlike in 2009, many EMs now face closed or outright positive output gaps, advanced positions in their domestic credit cycles, elevated commodity prices and still-accelerating core inflation. As DM central banks loosen their monetary policy stances, EM inflationary pressures are bound to rise in the short term if pegs are kept in place.
Figure 5: EM Policy Rate and Reserve Requirement Changes Over 12 Months to July 2011
Source: National central banks, RGE
*Weighted average of the CBT’s reserve requirements
There is evidence that suggests EM central banks are already reassessing growth and inflation conditions, and consequently their policy trajectories.
Figure 5: EM Policy Rate and Reserve Requirement Changes Over 12 Months to July 2011
Source: National central banks, RGE
*Weighted average of the CBT’s reserve requirements
There is evidence that suggests EM central banks are already reassessing growth and inflation conditions, and consequently their policy trajectories.
Bank Negara Malaysia, the Bank of Korea and the Bank of Israel all kept interest rates on hold in recent weeks, despite positive macroeconomic indicators and accelerating inflation.
As DM central bankers become increasingly biased toward looser policies—with exceptions such as Norges Bank opting to pause—EM central bankers are likely to favor pausingtheir tightening cycles rather than loosening.
Since our last Central Bank Watch, we have revised our near-term rate forecasts from hikes to extended pauses for five of the eight EM central banks we track.
Even the ostensible exception, the Central Bank of Turkey—which cut its one-week repo rate by 50 bps on August 4—has tightened other policy levers that have driven the cash loan rate up 400 bps since June.
Figure 6: Current RGE Policy Rate Forecasts, Compared to the June 8 Central Bank Watch
Source: RGE
Red text indicates a downward revision from the previous Central Bank Watch.
Such divergences in EM and DM monetary policy will help maintain the interest rate differentials that have driven global capital flows over the past two years.
Source: RGE
Red text indicates a downward revision from the previous Central Bank Watch.
Such divergences in EM and DM monetary policy will help maintain the interest rate differentials that have driven global capital flows over the past two years.
To stave off currency appreciation and retain export competitiveness, we may see export-dependent EMs adopting easier monetary policies going forward, but even EM rate cuts would not be enough to stem the tide of capital inflows released by loose DM policy.
The pressure among EM central bankers to prevent currency appreciation will be even greater should China re-peg to the USD, as it did in 2008.
However, China’s own battle with the trilemma may explain the yuan’s continued appreciation against the USD in recent weeks, despite a downturn in the global outlook: The inflationary costs of an exchange rate peg have simply become too high.
If CNY appreciation persists, other EMs will likely follow China’s lead and allow their own currencies to appreciate, raising the purchasing power of EM consumers and accelerating the shift of global final demand away from DMs.
Depression Prevention
This outlook is contingent upon our base-case forecast of around 2.2-2.4% annualized growth in DMs over the next six quarters.
However, U.S. growth is already on watch for a downward revision to below 2% in H2 2011, as downside risks remain formidable.
The contentious U.S. debt debate will be picked up again in November and December, around the same time as the deadline for ratification of the European Financial Stability Facility (EFSF) extension agreed upon in June and July.
A derailing of the former would bring automatic, across-the-board cuts to every federal government program, essentially front-loading more fiscal austerity on top of the significant fiscal drag that we have already penciled in for 2012 from the end of various stimulus programs.
A collapse of the EFSF agreement would wreak havoc on global financial markets.
Such event risks exacerbate the already-fragile imbalances rendering DMs on the verge of a double-dip recession.
Finding a way to muddle through without a big-bang crisis will put enormous pressure on the Fed and ECB to maintain life support for their respective economies over the next several quarters.
To this end, the Fed is said to be considering a number of unorthodox policies, including an explicit inflation target, price level target and nominal GDP target.
Other ideas that have been floated include Treasury yield targeting, lowering interest payments on excess reserves and instituting foreign or domestic non-Treasury asset purchases.
We expect Ben Bernanke and company to steer clear of explicit inflation or price-level targeting given these policies’ potential to unhinge inflation expectations.
Non-Treasury asset purchases would strictly be made as a last resort to inject money directly into the economy.
For now, the Fed is likely to go with a “traditional” large-scale asset purchase (LSAP) program later this year (i.e., QE3), and perhaps start drawing up plans for QE4 that include explicit yield targeting.
Figure 7: Size of Central Bank Balance Sheets by Assets (Jan 2008=100)
Source: Fed, ECB, BoE, RGE
Meanwhile, the ECB may be dragged farther into the EZ debt crisis, as we believe the EFSF simply does not have the resources to cover Spain and Italy for an extended period of time, let alone support other sovereigns and/or banks in need of financial assistance.
Source: Fed, ECB, BoE, RGE
Meanwhile, the ECB may be dragged farther into the EZ debt crisis, as we believe the EFSF simply does not have the resources to cover Spain and Italy for an extended period of time, let alone support other sovereigns and/or banks in need of financial assistance.
The ECB’s bond purchase program has so far been sterilized by open-market operations, but the sheer magnitude of the program may eventually force a balance-sheet expansion, inaugurating Europe’s own version of QE.
Such a move would impose constraints on monetary policy, of course, given that the ECB would struggle to sterilize all of the bond purchases necessary to fully backstop larger EZ members.
But the EFSF is clearly proving to be a limited and inflexible substitute for the ECB in its role as buyer of last resort.
In our view, large-scale intervention or QE is not only desirable from the perspective of financial stability, but also from the perspective of monetary policy, given the rapidly deteriorating growth outlook in the EZ and globally.
The weak Q2 GDP data put additional pressure on incoming ECB chief Mario Draghi to unwind the central bank’s overly hawkish policy stance.
A New Policy Paradigm?
In the medium term, the persistence of global imbalances and insufficient demand will keep DM central banks pressed to maintain positive price growth and avoid a deflationary environment that could drag the world economy into a multiyear stagnation, or worse.
To that end, we may be witnessing the next great (r)evolution in global monetary policy, as the age of central bank balance-sheet management replaces the dominant inflation-targeting (IT) paradigm of the past 20 years.
Still, even multitarget, multitool mandates have their limits. The Federal Reserve is discovering, much as the BoJ discovered a decade ago, that monetary policy pursuant to generating sustained growth is largely ineffective in the face of large-scale private-sector balance-sheet stress.
Coming to terms with this reality requires a political consensus that has so far failed to materialize on either side of the Atlantic.
Coming to terms with this reality requires a political consensus that has so far failed to materialize on either side of the Atlantic.
Fiscal austerity is likely to continue in the U.S., UK and EZ over the next several years, unless a global recession persuades DM deficit hawks to loosen the purse strings and pursue more fiscal stimulus.
To make matters worse, we worry about China’s broken growth model, as macroeconomic fundamentals and internal imbalances point to, at best, a secular slowdown sometime after 2012, sapping the global economy of yet another engine of growth.
Thus, as central bankers reach deeper into the toolkit, they are likely to find that monetary policy, orthodox or otherwise, is doing little more than pushing on a string.
Senior Analyst James Mason contributed to this analysis.
Figure 8: RGE Policy Rate Forecasts and Market Interbank Rate Expectations
Source: Bloomberg, RGE
Senior Analyst James Mason contributed to this analysis.
Figure 8: RGE Policy Rate Forecasts and Market Interbank Rate Expectations
Source: Bloomberg, RGE
Note: The data cutoff for current policy rate and market expectations is August 16, 2011.
1. Countries are ordered within DMs and EMs by GDP share of the world economy from the April 2011 IMF World Economic Outlook, based on PPP exchange rates.
2. Policy rate expectations for DMs are from overnight interest rate swaps and for EMs are from forward rate agreements. Note that various risk and term premia mean that expectations derived from markets may deviate from investors’ pure expectations of future policy rates. Real GDP and inflation forecasts are from Bloomberg surveys.
3. “Outlook” indicates policy rate forecasts on watch for an upward (↑) or downward (↓) revision, including a shift up (↑) or back (↓) of the anticipated rate hike schedule.
2. Policy rate expectations for DMs are from overnight interest rate swaps and for EMs are from forward rate agreements. Note that various risk and term premia mean that expectations derived from markets may deviate from investors’ pure expectations of future policy rates. Real GDP and inflation forecasts are from Bloomberg surveys.
3. “Outlook” indicates policy rate forecasts on watch for an upward (↑) or downward (↓) revision, including a shift up (↑) or back (↓) of the anticipated rate hike schedule.
