Central Banks – juggling interest rates and inflation

Low inflation is dampening the effects of low interest rates and central banks are happy to let this happen

As guardians of the economic recovery and a bulwark against inflation, central banks have a tough juggling act to maintain.  This is made even more difficult as priorities shift from getting the economy moving again to keeping an eye out for inflation.  The consequences of this can be seen in central banks’ tolerance towards low inflation with low interest rates proving less helpful as prices remain depressed.  Central banks are letting this happen due to inflation being one ball that central banks dare not come close to dropping.

Too many balls in the air

Central banks have a lot of balls in the air to watch with their remit including managing the price level as well as ensuring stability in the financial markets (and maintaining employment levels in the US).  The number of balls has increased as monetary policy has become the main way to bolster the economy with governments in many countries refusing to use fiscal policy.  But it is inflation that typically remains the main focus of central banks. 

The aversion to inflation was put to one side amid the turmoil of the global financial crisis.  Efforts to prop up the money supply through quantitative easing would have normally also lifted prices but this did not stop central banks taking bold action.  As the threat of crisis has receded, so have measures by some central banks to help out with the economy.  This shift has been made more pronounced due to low inflation as depressed prices strip away some of the positive effects of low interest. 

Juggling priorities  

The rate at which prices are rising affects decisions made by companies on whether to borrow money.  Higher inflation makes low interest rates more attractive to businesses as any products purchased today will be worth more in the future making it easier to pay off debts.  The opposite is also true and flat prices will prompt some business putting off plans to borrow and invest.  The harm done by low inflation is even more pervasive if it is a reflection of a weak economy which seems likely. 

By not doing more to keep prices ticking upwards, central banks are consenting with some of the potential effects of low interest rates being taken away.  It is like a hike in interest rates without interest rates actually having to rise.  It is a sign of how much central banks worry about prices rising too fast that this is happening despite the economic recovery still lacking momentum and inflation close to zero.

Don’t douse the economic recovery

The various roles of the central bank can make it seem as if they are required to juggle fire and water at the same time.  Much has been left to central banks in the aftermath of the global financial crisis which has often resulted in monetary policy being pushed too far.  Central banks were never meant to take such an active role in managing the economy.  A return to their less controversial role of keeping a lid on inflation will come as a welcome relief.  It is, after all, their record on inflation that central banks will often be judged. 

However, it is still too soon to move against the potential threat of a jump in prices.  There is still scope to leave interest rates at their current low levels with other measures such as macroprudential policies available for sectors, such as the residential property market, where lending is getting out of hand.  There is a point in every juggler’s routine where everything seems set to come crashing down – let’s hope that this does not happen due to a premature hike in interest rates.

Emerging Markets – Caught in the Crossfire

US monetary policy has missed its mark and it is a handful of emerging markets that look set to pay the price

The big guns of monetary policy used to combat sluggish economic growth are about to be put away but the real damage may be just about to kick in.  The Federal Reserve adopted loose monetary policy to get the US economy moving again but it is elsewhere where the effects have been felt the most.  Having benefited more from the loose monetary policy than the intended target, some emerging markets look set to suffer as a policy reversal prompts US investors to stage a destructive retreat back home.

Danger zone

The proverbial printing presses at central banks are like the heavy artillery of monetary policy.  Central banks such as the Federal Reserve had been pumping out cash to buy bonds as part of quantitative easing.  Yet, the US economy had failed to fire up with companies unwilling to invest while spending remains weak.  Investors with cash in hand turned their sights overseas and targeted emerging markets where economic growth was still perky. 

The surplus US dollars helped to lower interest rates for borrowers in many countries which had not gotten caught up in the global financial crisis.  The reduced borrowing costs pushed up lending elsewhere despite not having the same effects in the US economy.  The muted effects of monetary policy in the domestic economy prompted the Federal Reserve to unleash even more firepower.  Money, like some things, is fine in moderation but the bombardment of US dollars inadvertently created its own minefield. 

Borrowers in emerging market were only given access to cheap cash by borrowing in US dollars for a short period of time.  This was fine as long as the prospects for the US economy were poor and US dollars were readily available.  But any significant improvement in the US economy would see investors shift their money back.  A stronger US economy would also push up the value of the US dollar and make it tougher for overseas borrowers to pay off any debts in US dollars. 

Collateral damage

Like solider stationed in a hostile region, investors were set up to bail when the opportunity arose.  Just the mere mention by the Federal Reserve in May 2013 that quantitative easing might be coming to an end was enough to trigger a rush by investors to get their money out.  Six months of market volatility followed even though quantitative easing did not actually end until October 2014.  With the Federal Reserve now mulling lifting interest rates up from their low levels, more upheaval seems likely.

This is because money often does more damage on the way out compared to the gains when it is initially welcomed.  Yet, the lure of cheap cash is too much to ignore.  Even the financial sectors in richer countries have shown themselves to be unable to cope when too much money is on offer.  Less developed banking systems in emerging markets are often even worse at putting any cash to good use.  This increases the likelihood that many borrowers will struggle when US dollars are harder to come by. 

As the aftermath of the global financial crisis has made painfully clear, a swift end to a lending boom is not something easy to get over.  In its attempts to deal with an US economy sagging under the weight of excess debt, the Federal Reserve has inflicted the same woes on others who are less able to deal with the consequences.  Like any form of warfare, it is the innocent victims that suffer the most.

Quantitative Easing – Getting less from more

The European Central Bank has been late to try quantitative easing and may find that additional euros cannot buy much relief

We all have the tendency to rely on the tried and true tricks we have found helpful in the past even when their usefulness has faded.  This also seems true of central banks who have come to rely on quantitative easing even though its effects show signs of fading.  Even the initial boost provided by the first attempts at quantitative easing was limited and the situation has deteriorated amid its continued application.  As the last major central bank to give it a go, the European Central Bank will not get much return from any extra cash. 

Why more is not always more

Economist should know that repeating the same policies does not always work considering a well-used idea in economic theory known as diminishing returns.  This concept refers to the way in which more of the same often comes with fewer additional benefits.  Economists use this to describe why the second plate of ice cream does not taste as good as the first or why one more cook in a crowded kitchen doesn’t necessarily improve the food. 

Printing more money, which is the basis for quantitative easing, sounds like a sure-fire way to generate economic growth but any economy can only handle so much money.  The world is already awash with cash even before central banks started with quantitative easing.  This means that every additional dollar, euro, or pound printed as part of quantitative easing is being added to an already substantial pile of cash.  With money already being hoarded by many companies and governments not wanting to spend more cash, there is not much use for any more.

No need for more

With the meagre effects of quantitative easing on the wane, it was the earlier versions that would have generated the most bang for each additional buck.  It was the Federal Reserve and the Bank of England that tried out the first rounds of quantitative easing – the goal was to push investors away from government bonds to more risky investments such as corporate bonds or stocks.  The hope was that this would help provide companies with easier access to cash and to perk up investors by boosting share prices. 

Not all of the extra dollars and pounds would have stayed local but also headed overseas to find places to earn more money.  This meant that the effects of quantitative easing would have been felt far beyond the countries where the cash was originally coming from.  It has been helpful in places such as Portugal and Spain with overseas investors buying bonds issued by the Portuguese and Spanish governments as worries about Europe eased.

With the effects of quantitative easing having already spilled across international borders, there is not much more to be gained from even more cash.  As such, the additional euros coming out of the European Central Bank following the recent launch of quantitative easing in Europe may not amount to much.  Any further action may also be limited as the saga over whether or not to implement quantitative easing has highlighted how the European Central Bank only has limited room for manoeuvre when running in opposition to Germany.  Now, more than ever, it is time to try something new.

Inflation – Hard to ignore again

Low inflation is a nuisance for central banks looking to increase interest rates but they would be wrong to dismiss it

Family get-togethers over Christmas often involve naughty children but it is inflation that is making trouble for central banks.  Inflation unexpectedly shot up in the aftermath of the global financial crisis but is now surprisingly falling despite a burgeoning economic recovery.  Central banks ignored the jump in inflation in 2011 and are now stuck figuring out how to deal with persistently low inflation.  The antics of inflation will be difficult to disregard a second time around considering that the causes for static prices are not all external.

Inflation acting up

The level of inflation is used as a measure to check whether all is well with the economy.  There should neither be too much inflation (suggesting an overheating economy) nor too little (which is a sign of weak overall demand).  With countries increasing sourcing goods from overseas, prices levels in any country can be influenced by prices of commodities on global markets.  This can push inflation in a different direction to the particular circumstances of any economy.

The best recent example of this was a plague of high inflation in 2011 when the economies of many countries were still in the doldrums.  The Chinese economy was still humming along despite financial turmoil elsewhere and China continued to buy up commodities on the global markets.  The result higher prices were most prominent in the UK where inflation topped five percent in 2011.  This bout of inflation was not just a brief spike with prices rising by more than four percent for over a year.  Despite inflation being well above its target of two percent, the Bank of England maintained its loose monetary policy to support the weak economy.  The argument behind this was that the inflation was temporary and not related to the underlying economy. 

Behaving badly again

Inflation is currently misbehaving in a different way and is causing concern due to being too low.  Prices are not rising by much due to lower commodity prices with the spurt of growth in emerging countries having run its course.  While this is a positive for consumers who benefit from a boost in spending power, low inflation is a source of anxiety for central banks.  The Federal Reserve and the Bank of England are getting set to increase interest rates to more normal levels.  Even the prospect of the economic recovery gaining further momentum would not provide central banks with enough of a reason for higher interest rates when inflation is around one percent. 

This irritation is not likely to go away anytime soon if the high inflation in 2011 is any guide.  Inflation is likely to slip even lower in 2015 as the effects of the plunging price for oil feeds through into the economy.  On top of this, swings in commodity prices tend to last for a few years so that inflation is unlikely to pick up for the next couple of years.  This would suggest that inflation will be below target for 2015 and 2016 which is the two-year time frame that central banks look at when deciding interest rates. 

Ignoring inflation would be naughty

Low inflation should imply low interest rates but central banks could choose to ignore this and raise interest rates away.  This is because the same argument as in 2011 could be applied – disregarding trends in inflation that are attributed to outside sources.  It is a convenient strategy for central banks worried about the economic recovery triggering a jump in inflation due to the potential for wages to rise as unemployment falls.  Such an outcome does seem optimistic considering that wages are not budging by much even as the economy picks up steam.

A further problem with turning a blind eye to inflation is that it is tough to gauge what the inflation level would be without the fall in commodity prices.  It is not as if consumers have money to spurge having been stuck with stagnating wages and considerable debts from the pre-financial crisis spend-up.  Sluggish prices are harder to dismiss considering that low inflation is also caused by weak domestic demand.  With inflation likely to continue to play up for a while yet, central banks will need to be patient and bide their time before raising interest rates or else it will be the central banks that may be the ones getting into trouble.

Bargain Low Interest Rates to Continue in 2015

Borrowing is likely to stay cheap in 2015 as a drop in inflation puts pay to talk of higher interest rates

Christmas is usually followed by a rush off to the sales but borrowers need not hurry as cut-price loans are likely to remain for most, if not all, of 2015.  Acting like retailers with surplus stock to sell after Christmas, central banks slashed interest rates after the global financial crisis.  Six years later, there are growing calls for this to be reversed in countries such as the US and the UK due to as a strengthening economic recovery backed by more people finding jobs.  Yet, plans for higher interest rates have been way laid with falling inflation suggesting that all is not well with the economy.  With unemployment and inflation likely to fall further in 2015, there seems to be few reasons for any changes to be made to interest rates over the next 12 months.

Shopping around

The Federal Reserve and the Bank of England are in the midst of a dilemma – like a shopper not sure of where to head first to snap up some bargains after Christmas.  Unemployment data suggests that the economic recovery is becoming more entrenched with the proportion of Americans and Brits without jobs now below 6%.  Yet, despite more workers being hired, companies are still holding back from investing to expand output.  Aggregate demand is also suffering due to cuts to government spending resulting in an economic recovery that is still patchy.

If the stuttering economy is giving central banks reason to worry, it is inflation that is the real sticking point getting in the way of higher interest rates.  The extent at which prices are rising (or falling) has been adopted by central banks as a gauge for the health of the economy.  It is thus a point of frustration that inflation is heading downward as other signs, such as lower unemployment, suggest that the economy is picking up.  These mixed signals from the economy mean that Federal Reserve and the Bank of England are caught in two minds in terms of what do to with interest rates.

Best to stay put

Things are not likely to get any easier for central banks considering that the trends in unemployment and inflation are not likely to change any time soon.  With companies not yet willing to spend big on new equipment, it makes sense to employ more workers (who are relatively cheap) to get things done.  Lower commodity prices is the main cause behind falling inflation and a rebound in commodity markets is not likely as shifts in demand and supply of commodities taking years to change.  Neither are consumers in any mood for higher prices considering that wages have not kept up with inflation over the past few years. 

All this suggests that 2015 will be more of the same and interest rates are also unlikely to change.  Some will argue that interest rates need to rise to give central banks leeway to act in case of other threats to the economy.  Others will claim that the economic recovery means that inflation will be just around the corner and central banks need to pre-empt any jumps in prices.  But these are risky strategies considering that a bit of inflation in the future will do less damage to the economy than a premature hike in interest rates. 

A still fragile recovery means that, like any shopper out after Christmas, the economy could also do with a bargain (in the form of low interest rates).

Central Bank – Emperor's New Clothes

With the myth of its power having been shattered, central banks need to get nasty to win back respect

Central banks are looking a bit naked as if stripped of their power.  Previously, central bankers such as Alan Greenspan were held in awe and ruled over the hearts and minds of investors.  This position of power stemmed from the perceived ability to soothe the fire-breathing financial markets.  Yet, the global financial crisis and its aftermath have shown this to be but a myth.  Part of the problem was that central banks wanted to be liked and keep investors onside.  With its generosity proving its downfall, the naked emperor may need to stop being so nice.

Pretenders to the throne

This fall from grace has happened swiftly.  The powers of central banks reached their peak just before the crisis hit.  Quick to blow their own trumpet, economists talked of a “Great Moderation” – a prolonged period of steady and stable economic growth coupled with low inflation.   Central banks had also shown themselves willing to step in during moments of strife and prop up the stock market.  This won them a strong following among investors who could be sure that central banks would send in the cavalry if there was trouble. 

The proverbial crown slipped and fell dramatically with the global financial crisis.  Not only were central banks proved to be not suitable guardians of the economy but their capacity to rally at times of trouble was limited.  Low interest rates and quantitative easing offered little respite from the plague eating away at the economy.  The potency of central bank policy has been eroded as its primary source of power, the ability to print money, does not mean much in a world awash with money.

The problem was exacerbated by central banks not having the freedom to act as their almighty reputation might suggest.  Part of this was due to internal restraints such as a chronic (but misplaced) fear of inflation.  Such worries about rising prices keep central banks from unleashing their full firepower when faced with crisis.  In addition to this, politics also often acts to stifle central banks.  Germans’ heightened aversion to inflation has kept the European Central Bank from doing more.  The Federal Reserve has also had to be mindful that its actions did not draw ire from Republicans who are typically hostile to any government intervention. 

Cursed by hubris

It also became obvious with hindsight that central banks may have built their dominance on a dubious myth.  The “Great Moderation” may have just resulted from good luck rather than good management.  It is easy to keep inflation down when cheap goods are flooding in from China while money was cheap as China was sending a considerable portion of its earnings as reserves and sending it back to the US.  Yet, the misplaced belief in the rule of central banks over the economy lead to ignorance of risks that central banks thought they had slayed. 

Central banks were happy to live off this aura while also being generous in its dealing with investors.  Yet, this kindness turned out to have a cruel twist with the support shown by central banks to financial markets sowing the seeds of crisis.  Although lauded at the time, the reign of Alan Greenspan has instead been shown to be like a king trying too hard to please his subjects.  Over this period, the Federal Reserve kept interest rates too low while investors made merry amid a booming stock market.   

Better to be feared than loved

The unruly nature of financial markets coupled with the flood of cash sloshing around in global finance means that a guiding hand is needed more than ever.  Having been knocked from their high towers, central banks have to restore some assembly of order in a world where the pull of its ability to print cash is diminished.  It may be best to follow the words of Machiavelli, a renaissance philosopher who theorised on power struggles in Medieval Italy, in that it is better to be feared than loved. 

In this vein, if it was a need-to-be-loved that got central banks, and the rest of us, into trouble, it might be time to get nasty.  Taking a harsh line against any potential distortions in the economy (using macroprudential policies) would win more respect than being too friendly.  To rule with a firmer fist seems a better fit at a time when the consequences of financial excesses are so pertinent.  This would help to usher in a more peaceful period if combined with greater regulation to keep the banking sector from getting out of hand.  More stability may even get investors to appreciate the value of tough love.  

Global Economy - Half-time Report

It is game on in Brazil but many are hoping for less thrills in the financial markets in the second half of 2014

Just like in a football match, the half-way point (of 2014) is a good time to assess progress so far and look ahead to the second half.  The first six months have been relatively boring but in a good way, after participants and spectators of financial markets have been riding by the seat of their pants over the past few years.  The game plan so far has been an emphasis on defence with central banks in Europe and Japan providing more support for their economies while tapering by the Federal Reserve has been at a measured pace.  Investors are betting on a quiet second half to 2014 but this will depend on whether the markets can hold their nerve when confronted by the prospect of tighter monetary policy.

Tension is building

The start of 2014 could be considered a success on a number of fronts.  There are reasons for optimism in terms of the economic recovery such as swiftly falling unemployment in many countries.  Share markets are buoyant suggesting that investors are willing to take on risk.  Interest rates on government debt have dramatically fallen for most countries in Europe whose debt has previously been shunned by investors.  The focus of policy makers is no longer on dealing with the potential for crisis but instead on bolstering the economy recovery.

The only problem with this is that much of the progress has been built on loose monetary policy which is due to come to an end.  Investors will have to manoeuvre around the winding up of quantitative easing and higher interest rates.  This will be like a football team losing one player in defence – not the end of the world but it opens up the potential for calamity.  One consequence is that it is unclear how the second half of 2014 will play out.

May 2013 proves us with one example of what is likely to happen sometime soon .  In this month last year, financial markets went into spasms as the Federal Reserve signalled that it would cut back on its monthly bond purchases that constituted its quantitative easing program.  A repeat of what has since been labelled “taper tantrum” seems likely but with higher interest rates as the trigger (maybe prompting headlines of “rates rampage”).  Another popular phrase has been “fragile five” after countries who suffered at the hands of financial market who can turn nervy at any time.

When will things kick off?

The game plan from policy makers adopted so far this year is likely to stay in place considering the relative calm in the financial markets.  The aim will be to not let in any goals (especially any own goals) rather than pushing to score gains in economic growth.  As a result, it is tough to see any big changes in the economy itself.  Dramatic improvements in the economy are not likely with governments continuing to mend their finances.  Loose monetary policy may also not be as useful as hoped in boosting spending by consumers or investment by firms even as the economy shows sign of getting a second wind. 

Whether the benign economic conditions continue into the next six months depends on the fickle nature of investors.  Like an erratic football striker who often gets stroppy, investors need to get their way in order to be kept happy.  Central banks will likely take a cautious approach so investors don’t retreat to the side-lines.  This is likely to result in the first hike in interest rates by the Bank of England, which is ahead of its peers in this regard, being pushed back to at least next year.  Further reasons for delay include other policy options being available to the UK central bank and a likely negative effect on the pound from any rise in interest rates.  Others such as the European Central Bank and the Bank of Japan likely have even more to offer in terms of loose monetary policy to play ball with investors.

The football world cup in Brazil has been notable for its outstanding goals and nail-biting action.  In contrast, many will be hoping that the financial markets in the second half of 2014 will be as exciting as a nil-all draw. But just like a game going into extra time and penalty, some excitement is inevitable as monetary policy tightens and it is something that the financial markets will have to cope with this year or next.

US Monetary Policy – Investors face stormy future

US investors have been blessed with calm seas of late but their good luck is unlikely to last

Monetary Policy has entered a period of calm after enduring something of a turbulent passage through the global financial crisis.  The unprecedented tempest which buffeted the banking sector led central banks to trial a number of measures never seen before.  Yet, since tapering of quantitative easing was launched at the end of 2013, it has been relatively smooth sailing.  Tapering has been implemented in steady waves so as to not shake the delicate stomachs of investors.  However, rather than signalling the end of the choppy weather in the financial markets, the current lull could just be the eye of the storm.

Skies clear following predictable monetary policy

Investors prefer favourable conditions in the same way as sailors.  A view far ahead to the horizon is prized in the financial markets as well as by mariners.  One element that helps investors to better plan a course for the future is having a predictable monetary policy as a guide.  Investors had come to rely too much on the Federal Reserve as a steady hand at the helm using quantitative easing to put some wind back in the sails of the US economy.  Problems thus arose when the Federal Reserve first floated the idea of trimming back its expansive monetary policy in the middle of 2013.

What was a stiff breeze for the US hit many emerging markets like a financial hurricane.  This is because a considerable portion of the money printed in the US had travelled the globe in search of more bountiful returns.  Some developing countries had become a haven for the extra cash but the money left in a whirlwind once the prospects for returns in the US picked up.  The resulting market turbulence pushed some countries to the brink of going under, but investors eventually settled down again after adjusting to the new forecasts.

The outlook for US monetary policy has brightened considerably with the steady progression of tapering.  The Federal Reserve has cut back its purchasing of bonds by US$10 billion at each of its meetings, which happen almost every month.  As a result, bond purchases have been reduced a few times already in 2014 and fell from US$85 billion in late 2013 to US$45 billion at the most recent meeting at the end of April.  The predictability of US monetary policy also survived the potential shipwreck that was the change in skipper from Ben Bernanke to Janet Yellen at the beginning of the year.

Forecast for storms ahead

All is well for now.  However, there may be trouble on the horizon as tapering is just the start of the Federal Reserve relinquishing its role of propping up the economy.  A bigger storm may be coming next year as interest rates have to be raised from their current record low levels.  The Federal Reserve has pledged not to change interest rates for a while as it monitors the economic recovery.  Interest rate hikes must happen sometime in the next year or so especially in light of the surprising improvements in the US job market.

The end of quantitative easing and higher interest rates are all part of a voyage back to normality.  It has been a strange new world in terms of both the financial markets and monetary policy following the waves of financial havoc over the past several years.  The recent squalls that hit emerging markets can be seen as a necessary part of this journey.  Nevertheless, other rough patches may still lie ahead considering that it is far from normal for US stocks to be pushing on record highs despite slow economic growth. 

While it is tough to gauge what normal should look like in terms of the financial markets, the signs indicate that rough seas lie ahead.  Emerging markets have already taken a beating which makes it likely that the next storm may strike US investors closer to home.  

Nasty Breakup from Forward Guidance

Central banks have been led astray by the policy of forward guidance and it is time to move on

There has been a big breakup in the world of economics just before Valentine’s Day.  Central banks in the US and the UK had been wed to the concept of forward guidance.  This policy involves keeping interest rates low will have greater potency when combined with an outline of how long the policy will remain in place.  With the impact of low interest rates on the wane, central banks in the US and the UK were courted by the idea of forward guidance as a way to eke more out of current policies.  Yet both the Federal Reserve and Bank of England have been caught with their pants down due to the failure of forward guidance to deliver an economic boost.  The falling out has been made worse by debilitating issues with policy execution.

Seemed like a good idea at the time

The Federal Reserve slashed interest rates to 0.25% in December 2008 while the Bank of England pruned UK interest rates back to 0.5%.  In the face of the harshest recession in a generation, this normally dependable form of monetary stimulus failed to have much of an effect.  Continued weak economic growth spurred on a search for something extra and resulted in central banks delving into more unconventional measures.  Quantitative easing (buying bonds with newly printed money) is one example of such measures, forward guidance being another.

It was thought that forward guidance would act as a means to encourage economic growth as low interest rates were not having much of an effect on borrowing by themselves.  The hope was that a pledge that rates would be kept low for at least a few years would be the catalyst that would kick-start lending.  However, the assumption that there was a pent up demand for loans was wrong (as Your Neighbourhood Economist thought it might be). 

Bad idea made worse by shoddy execution

If the thinking behind forward guidance was not the best, the implementation was worse.  Both the Federal Reserve and the Bank of England based the forward guidance on the unemployment rate.  Unemployment was seen as a reliable yardstick of economic performance so the two central banks used it as a marker for changes in policy.  This later became a stumbling block when the number of people out of work declined faster than expected catching out many others along with the central banks.

Having to readjust the policy of forward guidance has been a PR disaster for central banks for whom reputation is key to influencing the financial markets and achieving their goals.  The Bank of England recently explicitly dropped the link between interest rates and unemployment and the Federal Reserve is sure to follow suit.  The necessity for central banks to assuage concerns that interest rates may rise defeats the whole purpose of forward guidance in the first place.

The Bank of England has instead stated that it will rely on a wider range of economic data.  Despite protestations by Bank of England governor Mark Carney that forward guidance is working, the new policy is too vague to act as any guide to the future of interest rates.  The reworking of forward guidance has failed to find any love from the markets.  Expectations that the Bank of England would not be faithful and would hike interest rates sooner rather than later resulted in the value of the UK currency jumping following the statements by Carney.  The saga over forward guidance has left central banks wondering what went wrong but it is time to get out and start afresh. 

Uncertainty is still the only certainty

Sometimes you come across data that seems to capture the current mood.  This was the case with a survey by an investment firm showing that 32% of wealthy investors plan to increase their holdings of cash over the next 12 months.  This change in asset allocation toward cash is strange considering some investments such as stocks are having a stellar year while returns from leaving money in the bank have been dismal.  This high level of caution shown by investors, who typically have advisers telling them where to put their money, highlights the level of uncertainty faced by those trying to invest their money.  Yet with a number of possible hiccups on the horizon, cash seems to be the least bad of a poor range of options. 

The key concern for many investors is the upcoming reduction (so-called tapering) of bond purchases by the Federal Reserve.  Improvements in the US job market are expected to see the Federal Reserve cut back its monthly purchases of US$85 billion worth of bonds in the next few months.  One of the side-effects of this monetary policy has been to push investors away from bonds and into riskier assets such as stocks which has helped to lift the S&P 500 up 26% so far this year to record highs.  The actions of the Federal Reserve have grown to be the dominant factor in the direction of share prices with investors placing more stock in announcements from the central bank than data on the strength of the underlying economy. 

There has been a debate raging over the extent of the influence of the Federal Reserve with some degree of distortion inevitable considering the scale of the bond buying operations.  Share prices could be overinflated and a sharp fall might be necessary to find their correct value.  Alternatively, any changes from the bond buying end may be minimal and it may just be worries about what might happen that is scaring off investors.  Some experts argue that it is good news that investors are holding a lot of cash as it suggests that shares are not yet overpriced and this cash may still flow into the stock market over the next year.  However, in this scenario, the smart money would already be invested in stocks. 

The uncertainty is such that investors are shunning higher returns from stocks for much lower pay-outs from leaving money in their bank (the best efforts of Your Neighbourhood Economist resulted in yours truly being locked into cash for two years to eke out a miserly interest rate of 2.0% through a UK savings account).  Among the few certainties for investments over the next year or so is that a considerable amount of volatility is likely as investors try to figure out what the Federal Reserve will do next and how other investors will react.  Great if you like investing to be like a roller coaster ride, but the rest of us may be better off settling for meagre returns from our banks.  

Federal Reserve – preparing to taper

With crunch time coming up, the Federal Reserve puts in the groundwork for a key change in policy

In the long march of dealing with the aftermath of the global financial crisis, the recent baby steps taken by the Federal Reserve may be one of the most crucial parts of the journey.  The Federal Reserve is considering lowering the interest rate on reserves it holds for banks as part of a move to offset upcoming reductions (tapering) in its bond purchases which currently amount to US$85 billion each month.  This tapering is perhaps the most important policy change in the past 12 months with the health of the global economy in the balance, so the Federal Reserve is anxious to ensure all goes well.

The actions of the Federal Reserve have been keenly felt across the globe with stock markets everywhere buoyed by the extra cash sloshing around the international financial system.  This abnormal state of affairs where central bank policy dictates the movement of stock prices is increasingly creating distortions through excessive gains in stock prices.  A pickup in the US economy would mean that the extra stimulus is no longer needed, but a smooth transition as the Federal Reserve changes tack will be key to sustaining any economic recovery in the United States and elsewhere.

As such, the Federal Reserve has been keen to soften the blow to the stock markets with policies that act as a stimulus as it cuts back on the bond buying which has been the main focus of its expansionary policy.  The mere rumour that the Federal Reserve would buy fewer bonds resulted in the interest rates on 10-year US government bonds jumping from around 1.7% in May to almost 3.0% in September.  Forward guidance, with future hikes in interest rates linked to unemployment, was tried as a means to signal the intent to help the economy but investors did not buy it (see prior blog for more).  

Changes to interest rates on banks’ reserves which are under consideration will only probably have a minimal effect but it is the signalling by the Federal Reserve that may be more important.  By showing a willingness to continue to support the economy, the Federal Reserve eases concerns that its actions will trample over the nascent economic recovery.  Some of the best successes of monetary policy have taken effect through nothing more than the suggestion of future action, such as the promise by the European Central Bank to do “whatever it takes” to save the euro.  This convinced enough people that it put paid to the Eurozone crisis without a single bond being purchased or interest rate being changed.  

Your Neighbourhood Economist was previously critical of the Federal Reserve for not taking the opportunity to begin tapering in October but the extra couple of months have been put to good use in ensuring that the change in policy goes smoothly.  All eyes will now look to the next meeting of the Federal Reserve (17th to 18th December) when tapering may be announced especially if US job data released on the first Friday in December is seen as positive.  The Federal Reserve is taking a cautious line but it is worth ensuring that there are no stumbles in the finishing stretch.