To the Point - 2010, November


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To the Point - 2010, November

  1. 1. To the Point Discussion on the economy, by the Chief Economist November 2, 2010 Cecilia Hermansson Group Chief Economist Economic Research Department +46-8-5859 1588 No. 7 2010 11 02 Central banks face difficult choices Sweden’s Riksbank has given up its zero interest rate policy. For major central banks, it will take longer, even though this will increase the risk of future imbalances. Exit strategies have been put on hold. Instead more quantitative easing is planned. The costs, however, would seem to exceed the benefits. Too much responsibility is being placed on monetary policy to speed up the recovery. Deflation fears are raising interest in price level targets as an alternative to inflation targets. This could be a possibility for central banks that don’t already have explicit inflation targets, but the question is whether the target can be communicated to, and understood by, the public. The financial crisis shows that central banks may have to lean against the wind to fix bubbles in the credit and housing markets. In the complex monetary world we live in, simple policy rules won’t work any longer. Too early to relax The Riksbank announced last week that it was raising its benchmark interest rate to 1%. On October 6, its last fixed rate loan expired. This means that monetary policy will gradually normalise after the financial crisis. The key central banks (the Federal Reserve in the US, the ECB in the euro zone, the Bank of England and the Bank of Japan – G4) have reason to be envious of how much easier it is for the Riksbank to climb itself out of the crisis. Raising interest rates from crisis levels is a sign of strength. Of course, the G4 central banks are struggling with much bigger problems than the Riksbank. Among the difficult questions that need answers are: How long will policy interest rates remain around zero and what would happen if they stay there too long? Is more quantitative easing needed and what impact will it have on the economy, inflation expectations and central banks’ independence? How are central banks influencing global savings imbalances? What happens to monetary policy after the financial crisis, i.e., which targets will best accommodate the risk of deflation, or at a later stage high inflation? And is it time for new monetary targets that take into account the credit expansion and asset prices? This “To the Point” discusses monetary targets, and the advantages and disadvantages of quantitative easing. It also asks whether a major paradigm shift is in order following the crisis now that economic policy has become so complex from an international perspective. What have Western central banks learned from the financial crisis and how will monetary policy change? The G4 will maintain a zero interest rate policy Thus far the central banks in smaller Western nations have been the only ones to raise interest rates. This includes Australia and Norway (beginning in fall 2009) as well as New Zealand, Canada and Sweden (beginning in summer 2010). Among emerging economies, China and India have raised their rates. The common denominator among these countries is that the financial crisis has eased faster and the economic outlook is better than in the G4, where benchmark rates remain near zero. The lowest rate is in Japan, which cut its benchmark rate from 0.1% to between 0 and 0.1% on October 5. Here, the deflation problem is most visible. In the US, the benchmark rate remains between zero and 0.25%. Deflation fears have increased, but for most of the members of the Federal Open Market Committee (FOMC) deflation isn’t in their main scenario. Kansas City Fed President Thomas Hoenig thinks it would be good to raise
  2. 2. To the Point (continued) November 2, 2010 2 Chart 1: Policy Interest Rates in selected countries (%) Source: Reuters EcoWin 00 02 04 06 08 10 Procent 0 1 2 3 4 5 6 7 8 9 SwedenNorway Euro Zone UK Japan New Zealand Australia US Canada interest rates sooner than most other members of the FOMC. At the monetary policy committee meeting of the Bank of England (BOE), one of the seven members voted for a 0.25 bp hike in the benchmark rate, but the majority decided to keep the rate at 0.5%. BOE Governor Mervin King noted that downward pressure on inflation is at least as big as upward pressure. The European Central Bank has maintained its key interest rate – the lowest fixed rate on refinancing operations, or the refi rate – at 1%, but Eonia (the Euro OverNight Index Average), i.e., the effective overnight interest rate on the interbank market, has stayed below the discount rate during the crisis. As the ECB phases out support in the form of fixed-rate loans to banks, Eonia will close in on the refi rate. The ECB member most vocal about not waiting too long to raise interest rates is the Bundesbank President, Axel Weber, who potentially stands in line to succeed ECB President, Jean-Claude Trichet. For the majority of G4 central bankers, the argument in favour of maintaining a zero interest rate policy (ZIRP) is that economic prospects are weak. It will take time for businesses and households to adjust their balance sheets. Credit conditions have not yet normalised. Real interest rates remain too high considering today’s weak growth and high unemployment. The risk of deflation has increased. And there isn’t much room for another fiscal stimulus. Those in favour of raising interest rates and gradually phasing out the ZIRP have several arguments on their side as well. If there were another crisis, there wouldn’t be any ammunition left, and there would be a greater risk that the US and Europe find themselves stuck with ZIRP and deflation, just like Japan. Another question concerns the effectiveness of monetary policy in a ZIRP environment versus more normal conditions. Hoenig suggests raising the US benchmark rate to 1% and letting it stay there for an extended period. He is worried that excessively low interest rates will lead to an incorrect allocation of capital, disrupt the functioning of the financial markets, and contribute to incorrect risk pricing and new asset bubbles. While the US needs to focus on higher savings, ZIRP benefits those who borrow rather than those who save. Although low interest rates weren’t the only reason for the financial crisis in 2008-2010, monetary policy in 2002-2005 probably worsened the situation. Another stimulus is on the way While economic prospects have worsened and central banks’ policy rates are already at or near zero, there are still a few monetary tools left. Below we discuss the importance of good communication and a new round of quantitative easing. There is also the option of cutting interest rates on the reserves banks keep with the central bank in order to increase the incentive for them to lend the money instead. These measures are not as potent as rate cuts, however, and the effects are not as easy to measure. In G4 countries, another stimulus is on the agenda, whereas the question of exit strategies has been put off. Communication can make a difference The first step to further stimulate the economy is to announce that ZIRP will continue for an extended period and will be phased out at a measured pace. The Japanese central bank has announced that it will keep rates at zero until price stability is within reach and risks are under control: "BOJ will maintain the virtually zero interest rate policy until it judges, on the basis of the 'understanding of medium- to long-term price stability,' that price stability is in sight, on condition that no problem will be identified in examining risk factors, including the accumulation of financial imbalances." The Federal Reserve has announced that under certain circumstances it will keep its benchmark rate at a low level for an extended period: “The committee (FOMC) will maintain the target range for the federal funds rate at 0 to ¼ percent and continues to anticipate that economic conditions, including low rates of resource
  3. 3. To the Point (continued) November 2, 2010 3 Chart 2: Central Banks’ balance sheets in USD, EUR and SEK Source: Reuters EcoWin 08 09 10 USD,EUR,SEK(thousandbillions) 0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 2.25 2.50 ECB Federal Reserve Riksbank utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” What central banks can do is to stress that they will keep interest rates low for longer than the market expects to raise inflation expectations and to keep real interest rates low. A change in monetary targets could also be part of the announcement, i.e., that by introducing price level targets higher inflation will be accepted for a period of time. Quantitative easing: When no alternatives are available The other available option is for the central bank to buy long-term securities, e.g., government bonds or mortgage bonds. The purpose would be to increase the value of these securities (and reduce long-term interest rates) and to strengthen domestic demand. Cranking up the printing presses could lead to higher inflation expectations and lower real interest rates. The currency could also weaken, which would contribute to higher export demand. The Fed has bought mortgage bonds worth $1.45 trillion (10% of GDP) and government bonds worth $300 billion (2% of GDP). The BOE has bought £200 billion in UK government bonds, or 14% of GDP. The Bank of Japan has bought ¥13 billion in Japanese government bonds, equivalent to 3% of GDP. These measures are designed to improve the functioning of credit markets and to stimulate the economy by easing monetary policy. Note that the ECB has not wanted to change monetary conditions through quantitative easing; €60 billion in covered bonds (0.6% of GDP) and an equal amount of distressed euro bonds have been bought mainly to improve liquidity in certain markets. Now that the financial crisis is abating, there is less need for such measures. The US, Japan and UK are interested in quantitative easing as a way to further stimulate their economies by easing monetary conditions (both interest rates and currencies). Japan has decided to create a ¥5 trillion fund (slightly over 1% of GDP), but the financial market feels this is too little to make a difference. The BOE is discussing a further easing of around £50 billion, i.e., about 3.5% of GDP, but no decision was made at its last monetary meeting. In the US, discussions have focused on a new easing. Previously there were expectations of something big happening in the financial markets, but that has been tempered somewhat. If the Fed decides against another easing, there would be a lot of disappointment, since the stock and bond markets would benefit from such a decision. To some extent the market is now driving monetary policy through its expectations. If the quantitative easing is as high as $1 trillion, e.g., $100 billion per month for 10 months, the entire budget deficit would be financed for a year by cranking up the printing presses. At the most recent monetary meeting on September 21, the Fed decided to use the repayments of previous bond purchases to buy new long- term government bonds, keeping their value at around $2 trillion. Another round of the easing that inflates its balance sheet could be warranted if the economic recovery needs more support and to allow inflation to rise to levels more consistent with the Fed’s implicit target (probably around 2% or just below). Pros and cons with quantitative easing Members of the US Federal Reserve have differing opinions about the benefits and costs of quantitative easing. The majority seem to support another round of easing if the economy needs it. The most negative member would appear to be Kansas City Fed President Thomas Hoenig, who has opposed the central bank’s decisions at recent meetings. The Fed’s discussions have been widely reported in the media, so much so that some observers have jokingly called the FOMC the “Federal Open Mouth Committee”. The advantages of a new round of quantitative easing usually mentioned are as follows: 1. A quantitative easing will help to reduce long-term interest rates on the type
  4. 4. To the Point (continued) November 2, 2010 4 Chart 3: Inflation in the OECD and the US 1972-2010 (%) Source: Reuters EcoWin 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 Percent -2.5 0.0 2.5 5.0 7.5 10.0 12.5 15.0 OECD OECD trend US Core CPI of bonds that have been bought and also indirectly on other types of bonds. 2. The stimulus has given the financial markets a boost by adding liquidity during the crisis. 3. Higher inflation expectations reduce real interest rates, which would potentially stimulate the economy. 4. A weaker currency that increases export demand could also be a desirable side effect. Several studies carried out this year indicate that interest rates have fallen. Gagnon state that altogether the US easing has lowered 10-year government bonds by 90 bp and 10-year agency bonds by 160 bp. Neely also mentions the international impact as well as a 5% decline in the dollar. On the other hand, those measures were bigger than the ones now being discussed and were adopted when the financial crisis was at its worst and ZIRP wasn’t yet in the picture. The rate cut could be as little as 10-25 bp in a programme worth $500 billion. Consequently, the costs would very well exceed the benefits. The disadvantages include: 1. Quantitative easing seems to work best at the peak of a crisis, but has less impact when a recovery is in progress. It is tricky at best to try to determine the effects of quantitative easing, which also makes it hard to calibrate and communicate monetary policy. Should the Fed announce from the beginning how big the programme will be? Maybe today’s long-term interest rates are low enough? It’s going to take time to clean out all the bad debts. 2. The monetary base increases, but not the money supply, when the financial sector adjusts its balance sheets. This could change as the recovery continues. There are tools that in theory could be used to shrink balance sheets if needed, e.g., if inflation expectations rise too quickly, but it can be hard to implement them at the right time and to the right degree. 3. The risks faced by central banks increase when their balance sheets shift from focusing on short-term securities to long-term securities. Some agency bonds are probably more or less worthless. 4. Buying various types of securities disrupts the financial market and makes players dependent on what central banks do. 5. Financing the budget deficit by unleashing the printing presses means that it wouldn't have to be financed through higher taxes. On the other hand, these measures have to be phased out. This means that government bonds have to be sold, which would affect the market as well as the independence of the central bank vis-à-vis the administration. 6. A significant easing of US monetary policy would increase capital inflows to emerging economies, with the risk of financial stability. A significantly weaker dollar would adversely affect China's dollar reserves and force it to further diversify its currency portfolio, causing other currencies to appreciate. The risk of currency tensions increases when the Fed eases monetary policy, also keeping in mind that key Asian currencies aren't market-based and are pegged to US monetary policy. Finding an optimal monetary target Since the early 1980s inflation in OECD countries has trended lower. Central banks have successfully met their goal of price stability. However, the risk of deflation is now increasing. The question is whether central banks are competent enough to fight off the dangerous combination of falling prices, wages and demand. Which targets are available today and which ones should be? Among the G4 nations, the BOE and ECB have announced fairly clear inflation targets. The British target is symmetrical at 2%, but the central bank also has to support the government's goals of higher growth and employment. The ECB’s inflation target is below but close to 2%. Employment in the longer term is said to be driven by structural reforms rather than monetary policy. The Bank of Japan’s goal is price
  5. 5. To the Point (continued) November 2, 2010 5 stability and is quantified what seems to be symmetrically at between 0 and 2%. Its aim is to stop deflation and instead reach the inflation target. There is no similar goal for growth and employment. The Fed has dual mandates for its monetary policy: full employment and price stability. Since there is a connection between the two, the FOMC formulates targets based on long-term unemployment (as a percentage of the labour force) and the mandate-consistent inflation rate. Although it may seem that a central bank can mainly impact the inflation rate, while unemployment is determined by factors outside the Fed’s control, Fed Chairman Ben Bernanke has stated that focusing exclusively on inflation could lead to more frequent and deeper recessions. He has previously made it clear that he is interested in introducing a clearer inflation target in line with other central banks, but opposition on the FOMC seem to have been too great. The crisis showed that an inflation target based solely on consumer prices can also contribute to imbalances. A growing number of critics began to question the target, pointing to its one-sidedness. The consensus, however, was that the target, if made more flexible by extending it for a longer period, offered the advantages needed when it comes to finding an anchor for monetary policy (greater clarity, easy to communicate and easy to understand). There are two main reasons to introduce an inflation target in the US following the financial crisis. One is that such a target creates expectations that could help it to avoid deflation (it is possible, however, that such an anchor will not have much impact if introduced too late). The second is that if inflation expectations rise too quickly, an inflation target can create expectations that the central bank will not jeopardise the price stability target in the longer term. Lars E.O. Svensson, an influential economist specializing in monetary policy and Deputy Governor of Swedish Riksbank, has noted that there is a disadvantage with inflation targets in circumstances where the risk of deflation has increased. He stated in one of his speeches: If firms and households consequently believe that inflation will be very low in the short term and thereafter equal to the inflation target, then the average expectations in the slightly longer term will still be low and under the target. In such circumstances, with a zero interest rate, the real interest rate may still be too high even if the inflation target is credible in the longer term. One way to avoid this disadvantage is instead to have a so-called price level target, or what may also be referred to as “average inflation targeting”. A number of central bankers are now urging the US to introduce a price level target. See, e.g., Evans and Altig. Svensson explains price level targets as follows: Unlike an inflation target, a price level target has a “memory” in the sense that lower inflation or deflation during a period of time whereby prices fall below the target path will be compensated for by a correspondingly higher inflation in a later period to attain the price level target path once again. Frederic Miskin notes in his book “Monetary Policy Strategy” that the economist and Governor of the Central Bank of Israel, Stanley Fisher, in 1994 questioned price level targets because they could lead to fluctuations in production, as crises cannot be smoothed over and have to be compensated for. These targets probably work better when there are deflation fears rather than inflation fears, since it is easier to generate higher inflation than deflation. Research by the British and Canadian central banks indicates that we could shift to a hybrid of inflation target and price level target, as it is easier to communicate an inflation target, but that central banks would also announce that any errors will be adjusted in the future. Another question is whether the inflation target should be raised in order to increase inflation expectations and that it is easier to avoid ZIRP in the event of negative shocks. Blanchard of the IMF argued in favour of maintaining an inflation rate of 3-5%, so that there is enough room for a stimulus if needed. Those against raising the inflation target (e.g. Bernanke, Been) say that the costs
  6. 6. To the Point (continued) November 2, 2010 6 Chart 4: US Current Account (billion US dollars) and China’s Currency Reserves (thousand billion US dollars) Source: Reuters EcoWin 90 92 94 96 98 00 02 04 06 08 10 USD(billions) -900 -800 -700 -600 -500 -400 -300 -200 -100 0 100 USD(thousandbillions) -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 US Current Account (right hand side) China's currency reserves (left hand side) probably outweigh the benefits. There are big risks in deviating from the expectations of price stability that have already built up. It is usually difficult to raise inflation “a little” without it getting out of hand. There is a risk of higher nominal interest rates, which could complicate debt reduction. Slightly higher inflation could also lead to higher volatility and, consequently, an undesirable effect on living standards. Effects of global savings imbalances Monetary policy focuses on interest rates based on production/employment and inflation. Free-floating currencies then become a balancing item based on monetary policy, growth, trade, capital flows, psychology, etc. The problem is that there are countries that peg their currencies to the dollar, which means that the monetary policy they import is often too expansive. The currency is undervalued and contributes to imbalances in the global economy. Although the Chinese currency, the yuan, has begun to appreciate against the US dollar, it is still considered undervalued. Imbalances are growing rather than shrinking, as evident by the fact that the US current account deficit is increasing again and China's currency reserves continue to grow. Despite that the financial crisis showed that the savings surpluses that were built up in Asia helped to reduce real interest rates in the West, there is no framework in place to govern currency tensions and imbalances. The new round of quantitative easing in the US is launching a wave of currency adjustments. China is trying to diversify its currency portfolio and buying other currencies, in addition to real assets. The Bank of Japan is intervening to avoid an overly strong yen. The Korean central bank is doing the same thing, as is its Swiss counterpart. In Europe, deleveraging is impeded in the PIIGS countries when the euro appreciates against the dollar. Some emerging countries are introducing capital controls or taxes on capital inflows, but in all likelihood such measures can easily be avoided by financial markets actors. Leading up to the G20 Seoul Summit on November 11-12, expectations of greater cooperation have been played down. It was easier to coordinate fiscal and monetary policy. When many countries now seek to devalue their currencies in order to gain an export advantage, there is a risk of increased protectionism, trade wars, and weaker global demand. Small, export-centric European countries will be the big losers. The meeting of finance ministers in South Korea led to a debate on the US proposal to place a limit of 4% of GDP on current account surpluses and deficits. China didn't completely object, but Japan, Germany and Brazil did. In general, countries with large current account surpluses must accept that their currencies will rise in value, while countries with deficits need to see theirs weaken. For Japan, a stronger yen is a problem in that it could worsen deflation. What are needed are more structural reforms. This applies to the majority of Western countries in response to the crisis. The US proposal opens a debate that could continue and where proposals are taking shape. The most positive thing that can be said at this point is that the door remains slightly open. Should central banks lean against the wind? Central banks have claimed for some time that it is better to clean up after a burst bubble than to try to prevent one from arising. On the other hand, the Bank of International Settlements (BIS), thought it would be more effective to lean against the wind, i.e., raise interest rates slightly earlier to stop the credit expansion and housing bubble. The argument for not doing anything about bubbles seem rather convincing as it is 1) hard to determine whether or not there actually is a bubble, 2) hard to prick a bubble with the help of monetary policy because of how the transmission mechanism works, 3) not enough to raise interest rates a little, and significant hikes could threaten the economy, 4) hard to accept as the short-term costs aren't necessarily outweighed by the long-term benefits of avoiding a bubble, and also 5) Higher interest rates can create problems if the debt ratio has been
  7. 7. To the Point (continued) November 2, 2010 7 Chart 5: House Prices in selected Countries, Index 2000 = 100) 99 00 01 02 03 04 05 06 07 08 09 75 100 125 150 175 200 225 250 S DK SP US UK N IRL Economic Research Department SE-105 34 Stockholm, Sweden Telephone +46-8-5859 1000 Legally responsible publishers Cecilia Hermansson +46-8-5859 7720 allowed to rise, since it becomes harder to settle debts and the debt burden would be higher than if funding had been allowed to continue without the impact of monetary policy. On the other hand, this crisis shows that it can be fairly costly not to take financial stability seriously. It is a question of effectively regulating financial markets and introducing alternative measures that can limit credit expansion, e.g., amortisation requirements, mortgage ceilings. Is there still any reason to lean against the wind if these alternative measures have been called upon? Maybe not all the time, but keeping interest rates unusually low for an extended period is likely to create anomalies in the financial market, leading to incorrectly priced risks and incorrectly allocated capital. It can be more important to lean against the wind when raising interest rates slightly from an extremely low level of around zero than when interest rates are being changed from 3.5% to 5%. It is true that it is hard to determine when there is a bubble and what the fundamentals are, but as Ray Barrell from the British National Institute of Economic and Social Research (NIESR) said, “When you usually think there is a bubble, there is a bubble …” Sweden may not have a housing bubble right now, but tensions are clearly building and could create problems in a few years, leaving it more vulnerable to the next crisis. It is reasonable therefore that Sweden now raises its policy interest rate despite that relatively low inflation and prospects that it will remain low would seem to indicate that the Riksbank could have waited a little longer. A lower interest rate probably would not have created quite as many jobs as econometric models predict. On the other hand, it is reasonable to expect large imbalances if the ZIRP had continued longer than necessary. If global developments and a stronger krona allow, the policy rate can then be raised more slowly next year, but it makes sense from a risk management perspective to raise it from the low level we had during the financial crisis. In recent decades central banks have successfully reduced inflation. Econometric models are partly to thank for why monetary policy could be set more or less automatically based on some Taylor rule or similar assumption derived from the output gap and inflation gap. At the time you didn't need many members to push in one direction; it might have been enough with one person and a computer. Today the world is more complex: China and India’s growing roles in the global economy, savings imbalances, low consumer prices but high asset prices. There is a risk of deflation and a risk of new asset bubbles. Regulation of the financial sector is also a focus: what will be regulated and how much? In such a world, greater flexibility will be needed when applying monetary policy. Simple policy rules are no longer at our disposal. Instead greater “maturity” is needed from those who set monetary policy and from actors in the financial market who interpret the decisions. Monetary policy has now become as much art as science. Cecilia Hermansson To the Point is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions 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 To the Point.