Where to next for central banks?

Saving the global economy might have been the easy bit – now central banks have to find a way to get out of the limelight.

The outlook for the world economy is far from sunny but talk of impending doom regarding the fiscal cliff in the US or the collapse of the Eurozone seems to have passed.  Central banks have been called on like never before to save us from economic catastrophe and have developed new strategies to deal with the unique problems thrown up by the global financial crisis.  But the deeper the central banks get involved, the more difficult it will be for them to extract themselves from their new dominant roles in propping up the global economy.  Signs of economic recovery mean that this tricky task is at hand but the way out will not be easy.

The first to have to come up with an exit strategy is the Federal Reserve in the US due to a relatively robust economy with the US economy expected to expand by 1.9% in 2013 and growth of 3.0% forecast for 2014.  The third round of quantitative easing means that the Federal Reserve is currently purchasing bonds worth US$85 billion each month with a promise to continue this until there is substantial improvement in the labour market.  With the unemployment rate having edged downward from 8.1% in August to 7.6% in June, the chairman of the Federal Reserve, Ben Bernanke has begun to talk of tapering off its bond buying which will be the beginning of the a long process of winding up the aggressive loosening of monetary policy.

The loose monetary policy has not only involved central banks becoming considerable buyers in the bond market but also interest rates being set at record lows.  It is fair to assume that these policies have helped ease the pain stemming from the global financial crisis, if not having staved off economic meltdown.  Yet, the flipside of the dominant role taken by the central banks is that the reversing of these policies brings its own problems.  Central banks have typically been supported for their actions in the face of possible disaster especially considering the squabbling of politicians.  While policies that boost the economy during slowdowns will always be welcomed, measures that add headwinds to an economic recovery (tightening of monetary policy) are unlikely to make central banks popular.  Yet, the bond buying and record low interest rates distort the economy and may create problems in the future. 

So a return to normality in terms of monetary policy is inevitable but it will be a protracted process with purchases of bonds by central banks being pared back followed by interest rates being nudged upwards all depending on the state of the economic recovery.  This chain of events may start this year in the US, maybe in the summer but probably later in the year or in early 2014, and will take at least a few years.  The decision making of the Federal Reserve will face even more intense scrutiny in the media considering the influence that its actions have over the markets for bonds and stocks (see Caution - windy road ahead for explanation).  The glare of the media will make it difficult to keep the majority onside as even the much-revered former chairman of the Federal Reserve, Alan Greenspan, discovered after falling from grace due to having been seen in hindsight to have left interest rates too low for too long.

The other major central banks will have the luxury of following behind the Federal Reserve.  The European Central Bank cut interest rates in May 2013 in a mainly symbolic sign of its continued intentions to bolster the Eurozone where the economy is expected to weaken by 0.3% in 2013 according to the IMF.  The real possibility of a breakup of the Eurozone was almost single-handily put to rest by the European Central Bank’s willingness to do “whatever it takes” to save the euro (for more, refer to "Whatever it takes"). Yet, the lack of a recovery has left the European Central Bank on red alert – everything is on hold in case another crisis breaks out.  The central bank in Japan is heading in the opposite direction to its US counterpart and is ramping up its monetary policy in the hope of kick-starting an economy which has been stagnating for the past two decades (for the details, see All bets are ON).

So trying times lay ahead for central banks and the rest of us left trailing in the wake of their actions.  Not only will the direction of prices for stocks and bonds depend on developments in monetary policy but gauging the suitable tempo of change by central banks will be crucial in encouraging the nascent recovery in the global economy.  It may be the beginning of the end in terms of central banks saving the world but there is still a long way to go to get to safety.

Caution – Windy Road Ahead

Trends in the stock market are hard to spot at the best of times but upcoming changes to monetary policy will add a few extra twists and turns.

Trying to work out the right time to buy or sell shares is like driving at night with a busted headlight – only some of the road ahead is visible and it is best to proceed with caution.  Evidence suggests that even the so-called experts struggle to negotiate the markets better than anyone else.  Everything from nutty dictators in North Korea to the latest iPhone can throw the markets into disarray.  The task of investing in stocks has been made even more difficult due to extra funds in the financial system stemming from central banks everywhere printing money.  The actions of the central banks has given shares an extra boost but the resulting gains are expected to fade with more cash likely to be less forthcoming as the global economy improves.  With monetary policy now dominating movements in the stock market, the prospect of changes by central banks are likely to leave investors hanging on the edge of their seats.

The basic premise of shares in a company is that it entitles the owner to a portion of the profits in that company.  The value of shares will rise or fall depending on the company’s ability to generate profits in the future.  While profits also rely on circumstances at each individual company, it is the state of the economy in which companies operates that tends to dictate the direction of the stock market.  So it may seem like somewhat of an anomaly that some stock markets such as in the US are hitting record highs at a time when the outlook for the global economy is so dismal.  The reason behind all this is monetary policy. 

Central banks were quick to slash interest rates to close to zero with the onset of the global financial crisis, but when the low interest rates were having little effect in terms of the prescribed goal of boosting lending, a new policy of quantitative easing was adopted.  Central banks started to print money and use this to buy bonds with the hope of making borrowing even cheaper.  Yet in spite of all of these efforts, consumers and companies have been stuck in a cautious mood and loathe to part with their cash which they have stashed away instead. 

The surplus funds end up being invested in assets such as bonds and stocks.  Bonds would be the preferred investment due to being a safer bet amid these turbulent times, but with central banks spending billions buying up bonds (which increases prices and reduces returns), the meagre pay-out from bonds has seen funds flow instead into the stock market.  The extent of these cash flows is such that it is vagaries of monetary policy that have come to dominate the direction of share prices.  The underlying health of the economy only registers to the extent to which it has an effect on the bond buying of central banks and has created a paradoxical situation where bad news regarding the economy is good for shares as weak economic growth translates to continued action by central banks.

The return of growth in the global economy may help to cushion any weakness in share prices as the central banks wind down their operations.  In theory, steady economic growth ensures that corporate profits increase over time, and thus, the value of stocks is typically on an upward trend.  But with the possibility of ups and downs in the global economy, shares may end up being overpriced depending on the extent of a potential correction in the market due to the change in monetary policy.  The potential for a correction in the stock markets makes it tricky to call whether it is a good time to buy or sell with the added uncertainty likely to make for a bumpy ride if you have the stomach for it. 

Close your eyes and hope for the best

Some advice for how to ride out the upcoming twists and turns in the markets.

Your Neighbourhood Economist tries to remain impartial when writing, but like many people, has a certain amount invested in the topics that are mentioned on this blog.  For most of us, it is our employment which can make us vulnerable to the ups and downs of the global economy.  But for some who have a bit stashed away here and there, putting any extra cash to good use is a tricky predicament at this time.  It seems to be like riding a roller coaster in the dark – hence the title of this article – is the best investment advice that Your Neighbourhood Economist could come up with and here is why.

Investment options can be categorised into two types (or a mixture of both) – safe or risky.  With many countries in the developed world still suffering a hangover from the aftermath of the global financial crisis, it would seem as if the clever move would be to go down the safe route.  But the safe option - bonds - has been jumped on by so many investors that returns from bonds have hit record lows in many places, such as debt from countries like Germany or the UK, which are seen as refuges from the turmoil elsewhere. Even the banks with their own problems are paying out higher interest rates than the more prudent options in the bond market.

With such a meagre pay-off from playing it safe, money has been migrating to riskier options with higher returns with shares being the obvious example of a riskier investment.  As such, some of the indices for the big stock markets such as the Dow Jones in the US have hit record highs.  This may seem a bit strange considering the doom and gloom surrounding the outlook for the global economy but it is a phenomenon which has been engineered by central banks across the globe.  Their policy of printing loads of cash has been targeting increased lending and a boost to the prices of assets that you and I might hold such as real estate or stocks.  This increase in asset prices is meant to help us open up our wallets and be more willing to spend (a phenomenon referred to as the “wealth effect”) despite the lingering possibility of job losses and sluggish increases in wages. 

There is a fatal flaw in this scenario that makes investing in this seemingly booming market for stocks even more of a risk.  Central banks will have to shut off the flow of cash sometime.  The main concern for central banks is inflation and keeping it at a sufficiently low level.  But more money, when people actually spend it, leads to higher prices which will be the result of the central bank policies once economic growth returns in earnest.  So the flow of extra cash from central banks which has pumped up share prices will end at some point in time over the next few years.

The timing all depends on the state of the economy in different countries with the Federal Reserve in the US already signalling that it will soon taper off its buying of bonds depending on a continued fall in unemployment.  The European Central Bank has its monetary policy on hold for the moment as the economic situation in Europe gradually improves but may act if another crisis kicks off, while the central bank in Japan has ramped up its monetary policy with the stagnating economy seemingly impervious to previous bouts of monetary stimuli.

This puts potential investors on a scary part of the metaphorical roller coaster ride of investing in the stock market.  There has been a big drop in the market with the financial crisis and the upward turn as share prices bottomed out, but where to next?  To complicate matters, it is the cash coming out of the central banks more than the actual state of the economy that seems to dictate share prices.  This has led to a paradoxical situation where the stock market can fall due to positive news on the economy as robust economic growth would prompt central banks to shut off the flow of cash.  

The result is a lot of twists and turns ahead as the market players try to assess the future of monetary policy, the direction of the global economy, and how other investors will react amongst all of this.  What is bound to ensue is a lot of screaming over both the good and bad.  But with few other easy investment options available, there may be little else to do but invest in stocks, close your eyes and hope for the best.

All bets are ON

Both the government in Japan and many investors are betting on the power of monetary policy but it is not much more than a roll of the dice.

Japan has long suffered at the hands of the same problems that have hit Europe, and as a result, the central bank in Japan has also been a pioneer of the loose monetary policy which has since become the mainstream response to such problems.  The recently-elected Japanese government has upped the stakes with a further round of monetary policy which goes far beyond anything previously proposed.  Investors too have been putting their money on the line in the hope that the new measures will bring about a long awaited revival in the Japanese economy.  However, the limited effect of monetary policy so far in the aftermath of the global financial crisis suggests that this is nothing more than a gamble in order to avoid some tougher choices.

A massive financial bubble in Japan in the late 1980s has resulted in two decades of economic stagnation due to the now common culprits of the overpriced real estate market, overwhelming government debt, and a lack of sources of growth.  The interest rates have been set close to zero for more than a decade while the Bank of Japan has also pumped money into the economy.  Successive Japanese governments have held back from making the necessary reforms to help the economy unwind the imbalances built up during the boom years and instead amassed debt equal to 230% of GDP, rather than deal with the problems that the country is facing. 

The new wager on monetary policy involves a doubling of the money supply as part of measures to achieve inflation of around 2% in two years.  However, the new monetary measures will just be another stalling tactic if not combined with other policies which help to kick start business activities.  The immediate effect of printing more money is that the value of the yen has dropped from below Y80 to over Y100 against the US$.  A weaker yen is a boon for many of Japan’s manufacturing giants who have large exporting operations.  The boost to their profits along with hopes for a new beginning for the Japanese economy has prompted many investors to throw in their lot with the Japanese government and the stock market surging by almost 70% in 6 months until a recent setback.

Yet this is symptomatic of actions by governments and investors across the globe.  Booms and busts in any economy involve considerable transformation as businesses adjust to new realities and government can either try to facilitate this process of companies adapting, which helps the economy become more productive over the long term, or stand up against forces of inevitable change to ease the short term pain.  Prior faith in monetary policy has enabled governments to believe that central banks have the power to restart economic growth with less hardship.  But new engines of growth are not given the scope to expand and monetary policy is relied upon more and more to prop up the economy. And using monetary policy to weaken a currency and boost exports will only work as long as the country’s central bank is expanding their money supply faster than anywhere else (for more on this, see Currency Wars).

This complicates the process of selecting investments with a layer of politics being overlapped with normal considerations of business profits and economic performance.  And with monetary policy taking a more dominant role in the strength of the economy, investors find it necessary to track the actions of central banks rather than just corporate activities and economic indicators.  As such, investors are second guessing what the central banks will do while the central banks take their best shot at what they think will be good for the economy. 

It is questionable whether the current set of policies that are commonly employed by central banks have been of much use so it is a considerable punt by the Japanese government to put all its money on more of the same despite any consensus which suggests otherwise.  But it is a way of being seen to be proactive while actually avoiding backing more difficult choices which are more likely to pay off in the long term.  And with bets in the stock market following the government line, this will multiply the losers and add to the woes of those who actually try to sort out the mess in the future.

Will economic growth still be the norm?

Capitalism is an economic system that has generated masses of wealth but can we expect that to continue?

The recent trials and tribulations of the global economy would have made more than a few people question their faith in capitalism.  Stagnating economies shackled by convoluted politics and a chronic lack of business confidence have made economic growth seem like a thing of the past.  The capitalist system has powerful forces within it that drive the generation of wealth but the mechanisms which generate growth have been damaged by excesses built up in the run up to the global financial crisis.  It is still too early to tell when and even if the previous rate of economic growth can be reached any time soon. 

At its core, capitalism is a battle for productivity and efficiency.  Companies compete against each other to supply goods and services for a better price or higher quality than their rivals with higher profits as a reward.  Any products that are offered with even a slightly lower price tag or in a way that attracts more customers will ensure a greater market share and prosperity for the business selling it.  As such, firms have to constantly strive to improve their offering or else their survival will be called into question.  Companies that can do a better job of satisfying the needs of their customers lure in more business and increase in size.  This results in resources in the economy such as workers and money for investment being drawn into firms with the best business plans where typically fewer inputs are required to make customers happy.  And it is this relentless shift to businesses which produce more for less that is the key to growth. 

So, trying to stop capitalism is like trying to stop people making money.  But capitalism can suffer when resources are not available for successful companies.  Take workers for example.  A business looking to grow needs more employees but high levels of mortgage debt and the drop in house prices in many Western countries mean that people are not free to sell up and move somewhere else for a new job.  Immigrants, both skilled and unskilled, provide greater access to the necessary human resources but places such as the US and the UK are making it tough for foreigners to get visas.  

Lending by banks allows for rapid expansion of businesses but the finance industry is struggling with the consequences of having been too generous in the past and banks prefer to keep the cash in their vaults.  As a consequence, successful firms are hamstrung by a lack of funds for expansion. A further hurdle to success is competition from so-called zombie firms – companies that should go bust but are kept alive by low interest rates and banks not wanting to incur any bad debt.  This stops the productive firms from grabbing the market share that should reflect their better business practices.

The situation with the banks is made even more complicated by new regulations applied to the finance industry.  Deregulation over the previous decades unleashed creativity at banks which boosted the economy to begin with but went on to sow the seeds for the global financial crisis.  Re-regulation is necessary to ensure that banks can’t bring the global economy to its knees but the financial sector also needs to be free enough to move money around to more productive uses.  The uncertainty over where this new balance might be makes for a difficult environment for banks to operate in.

Whether the current growth path will be a temporary slowdown or a permanent shift to a slower rate of expansion is as yet unclear.  Capitalism has bounced back from previous setbacks but the past is not always a good guide for the future.  Even if a revival of the previous pace of progress is a possibility, more than three years have passed since the worst of the financial crisis hit the global economy in 2009 and the light at the end of the tunnel still seems some way off.  While capitalism has been seemingly unstoppable in the past, only time will tell if or when economic growth can be kick started once more. 

Recessions, Ice creams, and the UK economy

The UK economy is set for a triple dip recession but it may not be the last.

Children love ice cream cones but a chocolate coating makes it even better.  Ice cream can be covered in chocolate not once but twice and a double-dip ice cream cone was a real treat.  It is a pity that recessions don’t work the same way.  This is particularly true in the case of the UK which may be in the midst of a triple-dip recession after real GDP fell in the last three months of 2012.  Even worse than this is that the fear that a weak UK economy may dip into negative growth a few more times this decade. 

A double-dip recession is a relatively common flavour of recession.  It occurs when an economy rebounds after a recession but the ensuing growth is not strong enough to be sustained and the economy weakens again before an upward trajectory is finally achieved.  The reasoning behind such a growth path is that businesses and households will hold back on spending during a recession due to heightened cautiousness and uncertainty about the future but spending will pick up again once the economy seems to be improving.  If the delayed burst of spending is premature or small in size, the boost to the economy is only temporary and growth stalls until the economy has worked through the issues that caused the first recession.

Investments by companies in new factories or equipment are essential for an economy to return to sustainable growth.  But such investments fluctuate considerably depending on the business mood and companies will delay or terminate investment plans if the economy is not strong enough for the companies to earn a suitable return.  So growth will remain feeble with short periods of weak recovery followed by similarly short and shallow recessions.  Such is the background behind the triple-dip recession and why the third consecutive recession in the UK may not be the last.  This weak business cycle with minimal investment in the UK will continue until business confidence is revived.

 

What makes the state of the economy after a deep recession in the UK different from the plain vanilla type is the hard-to-digest problem of a banking crisis and the bitter tonic of austerity measures.  In the build-up to the global financial crisis, the UK economy was more reliant on its banking sector than most other countries.  High wages earned by employees in the finance sector helped boost spending and a willingness by banks to lend fuelled a real estate boom.  The excesses of the finance sector in the good times amplify the problems that need to be sorted when times turn bad.  The result in this case is that the UK economy is currently suffering from weak consumer spending and a decline in lending by banks.  Reregulation of banking activities has added further complication to sorting out the finance sector. 

The effect of the banks adding to the swings in the economy is further heightened through the government.  The buoyant finance sector provided extra income for the government when the economy was booming.  Not only did this boost of funds to the government quickly dry up after the global financial crisis but the government also had to use up valuable resources to step in to rescue the banking sector.  Having already spent the cash bonus, the government is now having to take money out of the economy in a manner which is the opposite of a fiscal stimulus through its austerity measures.  This is also not a problem that will be easy to sort out and government cut backs are expected to continue through to 2018.

Considering that a “triple-dip recession” is relatively new term, what comes next?  A quadruple-dip recession?  Even if the UK economy manages to survive without slumping to two consecutive quarters with negative growth (the common definition of a recession), years of slow growth are ahead.  The worst case scenario is Japan.  The extent of the economic stagnation in Japan is not measured in the number of recessions but in the number of decades for which there has been no substantial growth.  Japan also suffered a property bubble which triggered a banking crisis but on a larger scale.  Yet, like Japan, the UK still has a lot to do, such as finding the right balance between regulations and increasing lending at banks along with government measures to boost the economy.  Until this happens, hopes for recovery are likely to melt away like an ice cream cone on a hot day.

Winning the Ugliness Contest

Once popular with all the investors, the United Kingdom is beginning to fall out of favour as the diet of austerity measures proves to be too harsh.

A beauty contest is all relative.  It is not hard to be the prettiest when everyone else is ugly.  Such was the fate of the British economy during the Eurozone crisis.  It was not in the best shape but it still looked attractive compared to the turmoil in Europe and this lured in investors who snapped up bonds issued by the government.  But, with the worst of the Eurozone crisis now over and Europe no longer being shunned, it is the United Kingdom that is the object of attention for all of the wrong reasons.

The economy in the United Kingdom did see some benefits from the debt crisis across the English Channel in Europe.  The United Kingdom was seen as a haven in troubled times when investors needed to find somewhere secure to put their money.  As a result, the interest rates on government debt dropped below 2.0% to record lows (for more on this, see Not All Investors in Bonds Have Lost Money).  This has provided some relief as, even though slightly separated from the Eurozone and its troubles, the United Kingdom was in a spot of bother of its own with government debt of 82% at the end of 2011 climbing to 89% 12 months later.

But now that Europe is not the mess it was, the United Kingdom does not hold the same allure and its faults are starting to show through.  The austerity measures which have been introduced to tackle the budget deficit are sapping life out of the economy as money goes toward paying off government debt.  Following a decline in real GDP in the last three months of 2012, Britain is set to make headlines of the wrong sort with a triple-dip recession on the cards if the economy remains weak.  The dismal state of the economy means that Moody’s stripping UK government debt of its illustrious triple A rating last week was not much of a surprise as the reasons for the downgrading – the sluggish economy and high debt levels – were obvious to all.  But the attention on the ugly side of the UK economy is adding to the calls for more to be done to stimulate economic growth.

The coalition government in the United Kingdom which is headed by the Conservative Party has been adamant in its stance that reducing the debt is the best way to perk up the economy.  But this has been increasingly called into question as the theory behind such policies has stumbled in the face of the economic realities.  Studies done by the IMF also show that cuts to government spending have more of a negative impact on the economy than previously thought (for more detail, see Time for Plan B?).  The downgrading of the debt will add to pressure for a change in tact as it may prompt investors to move their money elsewhere and interest rates on government debt will rise as a result.  The higher cost of borrowing will increase the government expenses and eat into the savings the government has made through its austerity measures.  The weaker economy will also reduce the tax revenue for the government adding to its woes. 

With the economy not looking so good in comparison to elsewhere, the government and the central bank will have a harder task to win over the confidence of investors and to come up with a suitable regime of policies to keep the economy in reasonable health.  One consolation is that the constantly changing political and economic situation in various countries struggling with the consequences of the global financial crisis means that the time that the UK economy spends in the spotlight may be short.  In the same week, an indecisive election result in Italy makes it likely that it will be dragged out in front of the international media as the new candidate for the winner of the ugliness contest.