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The Global Economy No. 6 - September 11, 2012


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The Global Economy No. 6 - September 11, 2012: Awaiting the central banks

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The Global Economy No. 6 - September 11, 2012

  1. 1. The Global EconomyMonthly letter from Swedbank’s Economic Research Departmentby Cecilia Hermansson No. 6 • September 11, 2012 Awaiting the central banks  The European Central Bank (ECB) has delivered and had a positive effect on interest rates in the short term at least. Now responsibility falls on the crisis countries to ask for support and implement reforms. The terms that the ECB has now set for bond purchases appeal to Germany (though not yet the Bundesbank), but make it harder for the central banks to conduct monetary policy and at the same time maintain their political independence. On the other hand, central banks’ independence has already been limited, especially in the euro zone, where by far the biggest hope of a savior of the currency union rests with the ECB.  In contrast with the ECB, the Federal Reserve (Fed) is likely to launch a new program of quantitative easing – this time with a greater variety of asset purchases. The commodity and financial markets are pleased by this “unconventional monetary policy,” which would add liquidity, but the impact on unemployment will be small.  While many people expect the central banks to mitigate the crisis – and they certainly should try to – the effect on the real economy, including growth and the labor market, will be small, since monetary policy isn’t as effective when balance sheets are being repaired and interest rates are already low. Instead more should be done to develop “unconventional fiscal policy,” e.g., prioritize structural policy, broaden the tax base, introduce some form of tax on high income earners and cut spending that isn’t motivated by growth and employment targets.Hope rests on looser monetary policy Fourthly, there is a monumental institutional crisis under way in the currency union, which will takeThere are several reasons why the focus has time to resolve and will require all the support thatshifted as much as it has to central banks right now. can be mustered in a situation where the crisis isThe most obvious reason is the lower demand that also linked to the banks’ financing in recent years ofis spreading from the crisis countries in southern escalating government debt. For the euro, the hopeEurope to northern Europe and then to emerging is that the European Central Bank (ECB) willmarkets, Japan and the US. Looser monetary policy unravel the knots that politicians cannot seem to (atshould in theory ease the slowdown. least not quickly enough).Secondly, debt restructuring in the public sector The economic malaise is obvious, especially sincemeans tighter fiscal policy, which can be offset at the slowdown in China and India has been worseleast in part by slightly looser monetary policy. than expected and in turn has spread to Japan, Germany and other export-oriented economies.The third is debt restructuring in the private sector – Manufacturing industry has announced cutbacks,not least the banking sector – which creates the and while the service sector is holding up better, itneed for support from lower interest rates and more won’t be able to avoid a downturn either.liquidity in order to avoid even greater creditausterity. At the same time it should be noted that US equities and oil prices have not yet adjusted to the slower Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46-8-5859 7740 E-mail: Internet: Responsible publisher: Cecilia Hermansson, +46-8- 5859 7720, Magnus Alvesson, +46-8-5859 3341, Jörgen Kennemar, +46-8-5859 7730, ISSN 1103-4897
  2. 2. The Global Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 6 • September 11, 2012economy, though this is likely to happen in the near depression and deflation is greater than that offuture. Commodity prices will decline if demand inflation. At the same time interest rates are alreadyslows, but could hold up if supply disruptions low and the marginal benefit of another quantitativecontinue. easing has decreased. We also know that after a financial crisis, when balance sheets are in need ofGlobal purchasing managers index, S&P index and oil prices repair, it is more difficult to find effective monetary 80 140 policy. In reality, fiscal policy should be more 75 S & P 500 130 effective, but it cannot be tapped when government 70 120 debts have already risen to such high levels. 65 P M I output 110 Consequently, politicians should implement more extensive fiscal reforms and cut any spending that Index (diffusion) global 60 100 doesnt benefit growth and employment, while 55 90 broadening the tax base, eliminating exemptions 50 80 and temporarily introducing a tax on high-income 45 O il price 70 earners (but not to the same extent as in France). 40 brent in 60 That would leave enough room to finance USD educational investment and labor market measures, 35 50 especially for the young, after which greater focus 30 07 08 09 10 11 12 40 can also be placed on structural policy. So urce: R euters EcoW in In emerging markets such as India and Brazil,One way to boost confidence in the commodity and expectations of significantly lower interest ratesfinancial markets is if the central banks decide on could come to naught, since inflation has alreadyanother quantitative easing or additional rate cuts. risen and central banks have to be cautious toNew liquidity in Japan, the US and UK would avoid another period of overheating. Even Chinaimprove the mood of global stock markets at the cannot reduce its reserve requirements and interestsame time that the ECB’s bond purchases (which rates as much as many people expect, sinceare sterilized and cannot be counted as quantitative officials will show more restraint this time to avoideasing) would at least temporarily increase another real estate bubble.confidence in the euro’s survival. Government bondyields have declined since the ECB announced it ECB is developing new form of supportwas willing en masse to buy the bonds of the crisis The ECB decided not to cut its benchmark rate oncountries, provided that they implement reforms September 6, so it remains at 0.75%. Instead, thewhich are supervised by the EU and the IMF. focus was on its new bond buying program, at the same time that inflation is still relatively high and theTwo-year bond yields for Spain, Italy, Germany and the UK ECB may want to have ammunition left this fall. 8 What’s more, the importance of a rate cut is Italy 7 questionable under the circumstances, although it would probably be smart to cut rates slightly or in a 6 couple of stages if the recession worsens. 5 Spain Reducing financial fragmentation in the euro zone, 4 which means that the interbank markets havePercent 3 become more national and that interest rate differentials between countries are high, is instead a 2 goal for monetary policy. The ECB has therefore 1 launched a new bond buying program it calls 0 Germany UK Outright Monetary Transactions (OMTs). -1 This is how OMTs work. The ECB has promised to 07 08 09 10 11 12 buy bonds with up to a three-year maturity from Source: Reuters EcoWin crisis countries that have incurred rising andIt seems only reasonable that the central banks unsustainably high financing costs for their debt.maintain an accommodative monetary policy given There is no quantitative limit on how much the ECBthe arguments mentioned above. In developed can buy, and it will buy the bonds in the secondarycountries, primarily in Europe, the threat of market. In return the crisis country must apply for 2 (4)
  3. 3. The Global Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 6 • September 11, 2012support from the rescue funds and implement same way that they have been critical of itsreforms overseen by the EU and the IMF. There are predecessor, the Securities Market Program (SMP),no longer seniority levels affecting bond purchases which did not explicitly require reforms? Weidmannby other creditors, meaning that if a country defaults feels that the ECB is resorting to monetaryon its payments the ECB would lose its money financing, which is prohibited by the EU Treaty. Thealong with other creditors. The ECB will not allow risk is that taxpayers will ultimately end up footingitself to be affected by credit downgrades by ratings the bill if the crisis countries fail to lift themselvesagencies, which previously forced borrowers to find out of the crisis, creating a so-called death spiralnew collateral. To mitigate the risk of future with lower demand, austerity, etc. Then it would leftinflation, the purchases will be sterilized, which mainly to German and French taxpayers to clean upmeans that the banks will deposit with the ECB an the ECB’s balance sheet.amount equivalent to the bonds they sell, which theECB will pay interest on, or that the ECB will issue It is worth noting that Germany’s weight was 27%,treasury bills in exchange for the banks’ liquidity. In but as Ireland, Greece and Portugal no longer havethis way the OMTs cannot be characterized as a weight Germany’s has risen to 29%. If Spain andquantitative easing, since no additional liquidity has Italy were to seek support, they too would no longerbeen added to the monetary system. be guarantors and their weights of 13% and 19%, respectively, would disappear, which would raiseThe financial markets have already responded Germany’s weight much more than to date.positively to the program, since interest rates havefallen not only for short-term but also longer Euro zone GDP growth and growth in money supply (M1)maturities. The stock market has reacted positively 5,0 <---- GDP Growthas well. The question, however, is whether the 4,0 13,0effects will be longer lasting this time. What are the 3,0problems and uncertainties associated with OMTs? 2,0 10,0Is this just another proverbial can that will be kicked 1,0 7,0down the road by politicians to buy themselves Percent Percent 0,0time, but where the measures are soon revealed as -1,0 4,0being insufficient? -2,0 1,0Against its will, the ECB has now taken another -3,0 Growth in real M1 --->step further from conventional monetary policy, -4,0 -2,0since the bond purchases will be conditional on -5,0political reforms. This is risky. What does -6,0 -5,0conditionality mean in terms of the ECB’s 96 98 00 02 04 06 08 10 12independence? Will it stop buying bonds if a Source: Reuters EcoW incountry’s loan costs are in line with fundamentals? We are also waiting for Germany’s ConstitutionalHow easy will it be to stop buying bonds from a Court to approve the ESM, the more robust of thecountry that doesnt institute the intended reforms, two rescue funds, which can provide supportand will the ECB be able to sell off these bonds without appealing to national parliaments, therebyeven though it could cause a panic and crisis reducing the sovereignty of Germany and othercountries may have to exit the currency union? Is countries. The most likely outcome is that the courtthe program expected to reduce interest rates in the will approve the ESM, but add conditions. The focuscrisis countries even if they dont seek support is also on the parliamentary election in thesimply because expectations of support have now Netherlands, which could mean reduced support forbeen created? If thats not enough, Spain and “rescuing” the euro, as well as statements by theperhaps even Italy may have to ask for help from troika on the Greek reform program, which is thethe program, which could take time. basis for new support payments.It has been announced that the IMF will play a part The ECB is probably moving in the right direction,in supervising the program in the future, but it is since there really isnt another short-term solution tounlikely that the IMF will contribute any money, the euro zone’s fragmentation problem. At the samewhich will reduce its influence. time the conditionality that has been added to theWhat does it mean in practice that the German bond purchases make it more complicated for thecentral bank, the Bundesbank, and its president, central banks to act and endanger their politicalJens Weidmann, have opposed the OMT, in the independence. The question is whether there would 3 (4)
  4. 4. The Global Economy Monthly newsletter from Swedbank’s Economic Research Department, continued No. 6 • September 11, 2012have been any difference if the ECB had instead The US labor market has performed weakly to date,continued the SMP, but Germany wouldnt have and the addition of 96 000 new jobs was nothing toaccepted that, since the volumes are now expected get excited about, since no fewer than 368 000to be much larger. Furthermore, the central banks people dropped out of the labor force. As a result,have already lost some of their independence. unemployment fell to 8.1% despite that the increase in employment wasnt even enough to keep paceThe future of the currency union in reality rests with with the normal expansion of the labor force. Nowreforms by the crisis countries, decisions by euro expectations of QE3 are increasing and it is likelypoliticians to expand their cooperation to include that a decision will be made as early as this week.fiscal policy and bank supervision, economic policymeasures and better decision-making process. The US employment (change in millions)focus is now shifting to Spain and Italy and whether 0,75they decide to seek help from the reform andrescue programs. If they wait to do so, there is a 0,50risk that the OMT’s impact on interest rates will be 0,25as short-lived as the SMP’s was. Persons (millions) 0,00The Fed eases off the gas -0,25At the much-publicized annual central bankconference in Jackson Hole, Fed Chairman Ben -0,50Bernanke discussed options for easing monetarypolicy with interest rates already low. One -0,75possibility is to announce that benchmark rates willremain around zero even beyond 2014. It could -1,00 88 90 92 94 96 98 00 02 04 06 08 10 12also stop paying banks to deposit money with the Source: Reuters EcoWinFed, which could potentially lead to increasedlending. The most likely outcome is that the Fed will The question is how effective QE3 will be whendecide to launch a new round of quantitative easing there are structural problems in the US labor market(QE3). To date this has not created the anticipated which have to be met with more targetedlevel of growth and employment gains. Is there educational investment – a job for fiscal policy.anything to suggest that this time will be any There is still cyclical unemployment, however,different? One idea often heard is that the Fed (or which could be reduced if demand grows slightlythe Bank of England for that matter) could buy faster. As long as there is a lack of political will toassets other than government bonds. This has compromise on the national debt and budget deficit,been the model used for some time by Bank of small and medium-sized companies will remainJapan, which even buys equities. Where do you uncertain, which will affect their willingness to investdraw the line and how effective would it be to try to and hire. Once again, it’s fiscal policy that has to bereduce mortgage rates by buying mortgage bonds called upon. Fiscal creativity or unconventionalinstead? They would probably decline slightly more, methods are needed here as well.and there are already signs of slight growth indemand for housing and mortgage financing, but The commodity and financial markets will be happyfrom very low levels. At the same time there is a with more liquidity, but it is doubtful whether the realrisk in placing every possible asset on the Fed’s economy, including growth and the labor market,balance sheet. will react as hoped. Cecilia HermanssonSwedbank Swedbank’s monthly The Global Economy newsletter is published as a service to ourEconomic Research Department customers. We believe that we have used reliable sources and methods in the preparationSE-105 34 Stockholm, Sweden of the analyses reported in this publication. However, we cannot guarantee the accuracy orPhone +46-8-5859 7740 completeness of the report and cannot be held responsible for any error or omission in underlying material or its use. Readers are encouraged to base any (investment) on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’sLegally responsible publisher monthly The Global Economy newsletter.Cecilia Hermansson, +46-88-5859 7720.Magnus Alvesson, +46-8-5859 3341Jörgen Kennemar, +46-8-5859 7730 4 (4)