News in Charts: Monetary Policy Round-Up

This research note is provided by Fathom Consulting. All of the charts below and many many more, covering a range of topics and countries on both the macroeconomy and financial markets are available in the Chartbook to Datastream users at www.datastream.com. Alternatively you can access Fathom’s Chartbook at www.fathom-consulting.com/TR.

Back in April, we set out our view that the world’s major currencies were engaged in a race to the bottom. With interest rates at the zero bound, and with a combination of excessive public and private sector debt holding down domestic demand, policy makers in the developed economies wanted to loosen policy still further. Everyone wanted to be the ugliest horse in the glue factory. At the time, we judged the race too close to call. It was to be a photo finish between incoming Bank of England Governor Mark Carney, and his counterpart at the Bank of Japan – Haruhiko Kuroda. The loser, in our view, would be the ECB. But as the year has progressed, there has been much jostling for position.

In this week’s Alpha Now, we briefly take stock of the economic climate in the major economies, and consider the implications for monetary policy, and by extension for exchange rates. Contrary to what is reflected in market pricing, we find there are upside risks to sterling next year against most major currencies.

Monetary policy at a crossroads

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Monetary policy is at a crossroads. Following the collapse of Lehman Brothers in late 2008, interest rates were cut aggressively around the world. In the US, the Eurozone, Japan and the UK, the policy rate of interest has been at or below 1% for more than four years. Over the same period, the balance sheet of the US Federal Reserve has quadrupled. The balance sheets of other major central banks, including the European Central Bank, the Bank of Japan and the Bank of England, have also increased in size dramatically. The global economy is awash with liquidity, and with US dollar liquidity in particular. But now the US Federal Reserve is steeling itself to turn off the tap, or at least to reduce the flow somewhat. From 21 May, when Chairman Bernanke first mentioned the possibility of tapering, ten-year US Treasury yields have risen by just under 100 basis points. Gilt yields have risen almost perfectly in step. Bund yields have risen too, though the correlation here has been weaker. Only in Japan have yields remained at historic lows.

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Fed eager to taper

Minutes from the October meeting revealed a growing conviction among FOMC members that the pace of asset purchases ought to be reduced sooner rather than later, so long as the economic data did not deteriorate, and political risk did not escalate. For the first time there was explicit reference to the consideration of ‘scenarios under which it might, at some stage, be appropriate to begin to wind down the program before an unambiguous further improvement in the outlook was apparent’. To us, this constitutes a rather forceful acknowledgement that there is now questionable net benefit to further QE.

The difficulty facing FOMC members is that, in spite of fears that continued asset purchases risk distorting market prices, there is little appetite yet for a tightening of monetary policy. Although the headline unemployment rate is moving steadily towards the 6.5% threshold – and in our judgment it will cross it next summer – there are no signs of inflationary pressure. Indeed, the headline PCE measure stood at 0.9% in the twelve-months to September. That is the kind of level that in more normal times would be associated with a loosening rather than a tightening of policy.

ECB considering its options

Earlier this month, the ECB’s Governing Council unexpectedly voted to lower its main refinancing rate to just 0.25%. In spite of the improvement in market sentiment towards the Periphery, the Eurozone as a whole has yet to enjoy a sustained period of economic growth. Of the big three economies, only Germany appears to have escaped from recession. At the same time, inflation has slowed sharply this year, with the flash estimate for November coming in at 0.9%. Most of the Peripheral economies are in, or close to deflation, further threatening their fiscal positions.

Against this backdrop, members of the Governing Council have been rooting around in their policy toolkit to see what more can be done. Some have advocated the re-introduction of long-term refinancing operations (LTROS), used to good effect through last year. Others options range from Quantitative Easing – an approach recently recommended by the OECD – to a system of negative deposit rates. Our own work suggests that, contrary to what might appear intuitive, the latter could put upward pressure on EONIA.

BoJ losing confidence in its ability to meet the 2% inflation target

Japan’s QQE programme has succeeded in pushing inflation back into positive territory, in large part owing to the impact of a weaker yen on the price of energy imports. The headline measure reached 1.1% in the twelve months to October, while the so-called ‘core core’ measure, which excludes changes in both food and energy prices, came in at 0.3% – the first positive reading in five years.

Nevertheless, as we have written at length in recent months, the difficulty is that wages have yet to respond. In the twelve-months to September, contractual pay rates actually fell, by 0.4%. Moreover, the sharp depreciation of the yen is yet to bear fruit, with Japan’s trade deficit continuing to widen. In these circumstances, the Bank of Japan’s latest forecast, which is for growth of 1.5% through fiscal years 2014 and 2015, looks far too optimistic. Even members of the Policy Board are starting to doubt that the 2.0% inflation target for fiscal year 2015, previously described by Governor Kuroda as ‘very ambitious’, can be met.

UK economy hotting up

In the UK, a series of government policies aimed at boosting the supply of credit have started to bear fruit. Growth has picked up substantially through 2013, and in 2014 we expect the UK to outperform all of its advanced economy peers bar the US. This dramatic turnaround, fuelled by a pick-up in private consumption, has changed the nature of the debate. As recently as June, three of the nine members of the MPC voted for more QE. Now attention has turned to the timing of the first rate rise, with some forecasters expecting this to happen as early as the middle of next year.

At his first Inflation Report press conference back in August, Governor Carney set out a policy of conditional forward guidance. Subject to a number of ‘knockout’ clauses relating to perceived risks to financial stability and to inflation, the MPC has committed not to raise Bank Rate or to reduce the stock of asset purchases at least until the unemployment rate has fallen to 7%. Back in August, the MPC did not expect that this would be breached at least the end of 2016. In November, an upward revision to the Committee’s assessment of growth prospects meant that this point was brought forward to the end of 2014.

The key question for us is: ‘how will UK productivity respond to the marked pick-up in demand?’ The MPC still expects productivity growth to recover and return to a trend rate of around 2%. In our view, the UK’s supply capacity has been weakened by the crisis and we see output rising substantially faster than productive potential through next year. This means that strong growth will feed through into higher inflation quite rapidly.

Simple rules for monetary policy

As long ago as 1993, US economist John Taylor observed that the actions of the Federal Reserve could be reasonably well approximated by a simple rule that involved setting the policy rate of interest equal to the neutral real rate of interest, plus current inflation, plus some weighted average of the output gap, and the deviation of inflation from its desired level. Usually, these weights were set at (0.5, 0.5). This simple rule, known as the Taylor Rule, has since become a popular metric for judging the stance of monetary policy in different countries.

In the chart below, we show the policy rate of interest suggested by the Taylor rule as applied to macro-economic data for the US, the Eurozone, Japan and the UK. We use the OECD’s estimate of the output gap for each country, and set the neutral real rate of interest equal to the OECD’s estimate of trend growth. In each case, we assume an inflation target of 2.0%.

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It is widely recognised that, during the crisis, the response of many central banks to macro-economic shocks changed dramatically. A simple Taylor Rule would have recommended that policy be tightened in the US, the Eurozone and the UK in response to a period of above-target inflation through 2010 and into 2011. But policy rates remained at, or close to the zero bound. There are many reasons why policy makers might have behaved differently through the Great Recession. First, it is likely the risks to a policy mistake were rightly judged to be asymmetric, with the consequences of tightening too soon far worse than those of tightening too late. Second, it is undoubtedly the case that credit spreads were, and to a degree still are unusually wide. For a given official rate of interest, policy is tighter now than it would have been before the crisis.

With some major economies now enjoying successive quarters of economic expansion, it is perhaps worth revisiting these simple rules. We find it striking that, the UK aside, the Taylor rule would in fact advocate something close to a zero rate of interest in the major economies. In drawing this conclusion, we are of course treating the Eurozone as a single entity. While policy might be about right for the region as a whole, it is perhaps too lose for Germany, and it is certainly too tight for Greece. Arguably, our chart comparing Taylor Rules in Germany and Greece provides strong evidence that those two countries never belonged in a Monetary Union – a case of ‘one size fits no-one’.

According to the Taylor Rule, there is no compelling case for a policy tightening in either the Eurozone or Japan. That is hardly surprising – both the ECB and the BoJ are looking to loosen rather than to tighten policy. But the Taylor Rule suggests there is no compelling case for a tightening in the US either. The Taylor Rule suggests that policy remains unusually loose only in the UK. Using the OECD’s estimate of the UK output gap, which currently stands at -2.5%, Bank Rate would normally be at a little over 2.0% according to the Taylor Rule. In Fathom’s view, UK potential output has fallen much further than most official forecasts acknowledge. In our view, the output gap has already closed. On that basis, the Taylor Rule would suggest that Bank Rate should be around 3.25%.

Conclusions

A case could be made that 2013 was a relatively quiet year for central bank watchers. Only one of the so-called ‘big four’ changed its policy rate of interest, and even then the move was one of just 25 basis points. But this is to understate dramatically the shift in sentiment that has taken place through the course of the year. Back in April, official rates of interest looked to be on hold indefinitely across the major economies. Against a backdrop of weak domestic demand, the ‘big four’ central banks were engaged in a race to the bottom, with each hoping for a weaker domestic currency.

Now, as we reach the end of the year, the Federal Reserve is anxious to bring its asset purchase programme to a close, even though a 25 basis point increase in the Fed Funds rate is not fully priced in until late 2015. Against a backdrop of strengthening consumer demand, the Bank of England is expected to tighten first, with an increase in Bank Rate to 0.75% fully priced in by mid-2015.

In Fathom’s view, the Bank of England will come under increasing pressure to tighten policy next year. With the output gap closed, and with productivity unlikely to respond to the pick-up in demand, UK inflation is likely to rise steadily through 2014, reaching somewhere close to 3.5% in the final quarter. Initially, this will put upward pressure on sterling. In the short term, and contrary to market pricing, we see upside risks to sterling against most major currencies. The big question is: will the MPC deliver? Our concern is that fears about triggering a second collapse in the UK housing market might cause the Committee to hold fire. As we set out earlier this month, if it waits too long, we risk seeing a gold old fashioned sterling crisis.

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