Unconventional unconventional policy
This post is a guest contribution by Manoj Pradhan and Spyros Andreopoulos of Morgan Stanley.
The global economy is in trouble again and policy-makers face a daunting task. Compared with 2008, however, the polarity of the economic and policy scenarios has almost reversed. Back then, economic conditions were very poor, to put it mildly, and downside tail risks were abundant. Policy options, on the other hand, were abundant too and were used aggressively. Today that situation has almost been turned on its head. Economies are by and large in much better shape today (barring Peripheral Europe), but policy globally is significantly more constrained than it was then. While there are obvious constraints on fiscal easing in the DM world, thresholds are higher for monetary easing as well thanks to inflation. Core inflation in the US has been rising steadily, inflation has catalysed the ECB into action and EM central banks have just finished a six-month battle with inflation.
The thresholds for monetary easing are falling. Inflation is becoming less of a problem everywhere as growth risks take centre stage. Even if the thresholds to monetary policy no longer remain binding, the question remains: does the global central bank have enough firepower left to meaningfully boost growth? Yes, is our short answer. EM economies have a mix of monetary and fiscal legroom, with a huge stockpile of excess reserves that can backstop the risks from credit or fiscal easing. On the DM side, we argue, an unconventional look at both conventional and unconventional monetary easing could deliver a potentially effective monetary easing. The biggest risk to the scenario of monetary easing described above is that policy-makers react later rather than sooner. Some early indicators of a drop in global growth and trade might be a blessing in disguise if they prompt policy-makers to act pre-emptively.
I. Thresholds to Monetary Easing
The FOMC yesterday stopped just short of delivering a first salvo of easing as it delivered more of a guidance about how long economic conditions will warrant low rates rather than a commitment to hold them there. However, its downbeat assessment of the economy and lower concern for inflation suggest that the threshold for another round of easing is now lower. Interestingly, the statement yesterday suggested that further easing may go beyond just mechanical balance sheet expansion.
The picture may be changing at the ECB as well. The high level of inflation and the risk of overheating in core European countries have been replaced by the risk of a spillover of the debt crisis and the possibility of a further slowing of growth. This has already pushed the ECB to reactivate its Securities Market Programme to purchase Italian and Spanish debt. An escalation of growth concerns might prompt the ECB to pause its tightening cycle or even consider rate cuts. Considering that a rate hike at its October meeting cannot be ruled out at the moment, it would be quite a reversal indeed.
Finally, the threshold for EM central banks to ease policy has been quite high recently because of its recent battle with inflation. However, EM PMIs have been falling and the recent increase in risks to US and European growth suggest more downside risks to EM growth. Weaker growth and strong base effects suggest lower inflation in the months ahead, giving policy much more legroom.
II. Policy Options for the Global Central Bank
It is true that the Global Central Bank has used up plenty of ammunition already to fight the Great Recession. But that does not mean it has no ammunition left. First, some central banks never exhausted their conventional arsenal, or have been able to replenish it since. Second, unconventional options have not been exhausted – indeed, unconventional measures are almost by definition plentiful, as the only constraints are the imagination of policy-makers and operational considerations. In fact, there is no limit to the amount of unconventional easing that central banks can deliver, given that they are the sole operators of the printing press. To understand policy options better, we split the outlets of the Global Central Bank into conventionals and unconventionals.
Unconventional unconventional easing at the Fed? In easing further, we believe that the Fed might have to take an unconventional approach to both conventional and unconventional easing. Expanding on the broad options laid out in Chairman Bernanke’s testimony from July 13, the Fed could venture further into unconventional territory by using some or all of the following strategies:
1. Unconventional cuts in the interest on excess reserves – into negative territory: A negative interest rate on excess reserves of commercial banks would incentivise commercial banks to direct these excess reserve holdings to either the purchase of assets or towards lending – both wholly desirable outcomes from the Fed’s point of view. The downside to a strategy of negative interest rates on excess reserves is that riskless money market rates would also venture into negative territory. The Fed would have to be willing to accept this trade-off of front-end rate volatility against the benefits of pushing a significant quantity of excess reserves from the banking system into the economy.
2. Unconventional unconventional easing: With nominal yields on 10-year US Treasuries near 2.5% and core inflation at 1.3%, it is safe to say that conventional QE purchases of Treasury bonds would take real yields close to or even below zero. A more unconventional version of unconventional easing might include the following choices.
• The Fed could take on a 1940s-style approach, keeping bond yields below (say) 2.5% for a period of time regardless of what happens to inflation.
• It could embark on a joint programme with the Treasury along the lines of the TALF in order to support the mortgage market. The Treasury would provide a financial backstop to the loans while the Fed would facilitate the programme. The Treasury would still have to find a source for the funds it would provide as a backstop for the programme.
• At the moment, there are legal and political hurdles to buying equities since the Fed is not mandated to buy public assets and would need congressional approval to do so, which would be very difficult to get, given the sensitive nature of this asset class. However, should the equity market prove to be the epicentre of market turmoil, and if the risk of this turmoil slipping into the real economy rises, the Fed could try to overcome these hurdles via a TALF-like SPV to hold the purchased equities, purchasing an S&P basket to avoid suggestions of favouritism, and taking its case to Congress.
• Finally, the Fed faces operational difficulties in buying equity or other private assets, but any desire to support risky asset prices could be met by the Fed taking a ‘long’ position in interest rate swaps. In simple terms, this would mean that the Fed would make regular fixed payments set by the ‘swap rate’ and receive regular payments according to a floating rate such as the LIBOR rate. Building up on positions like that would push the swap rate lower. Since the swap rate represents a ‘risky’ rate and plays an important role in the interest rate market, such a strategy (particularly if combined with Treasury bond purchases) would have the dual benefits of pressuring Treasury bond yields lower and compressing risky asset spreads. This would be akin to the strategy of purchasing MBS and Treasury bonds at the same time, but would use up significantly less balance sheet because there is no upfront payment on swaps, only the periodical exchange of fixed and floating payments.
3. Unconventional conditional commitments: The Fed could go a step further than its statement last night and make a commitment to not tighten policy conditional on time and/or macroeconomic outcomes. A Bank of Japan-style conditioning on macroeconomic outcomes could be an innovation worth considering. For example, a rule to not tighten policy until core inflation is 2% higher and unemployment 2% lower than current levels would eliminate the constraints of calendar time and give investors a clear scenario against which to set their expectations.
What’s unconventional for the ECB? The ECB allowed an expansion of its balance sheet at the same time as the Fed, but the approach it took to this expansion has flirted with the conventional boundaries of unconventional easing. While the Fed followed a strategy of ‘active’ QE (proactively pursuing an expansion of its balance sheet by purchasing assets), the ECB followed a ‘passive’ QE policy, which allowed an expansion of its balance sheet in line with the refinancing needs of private institutions. Its covered bond purchase programme was limited in its scope (buying a total of €60 billion of covered bonds) and all purchases through its Securities Markets Programme have been sterilised.
For the ECB, an unconventional look at unconventional policy would be a step in the direction that the Fed has taken in the past. The SMP is currently buying Italian and Spanish debt that will be turned over to the EFSF once the latter is operational. The ECB could deliver significant easing by instituting a large asset purchase programme with a defined target that is a significant number with respect to the GDP of the euro area (for reference, Fed and BoE asset purchases so far have amounted to around 15% of their respective GDP). Given where bond yield spreads are at the moment and considering the Fed’s profitable track record on its asset purchases, such a strategy should assuage ECB concern about losses. Whether it sees such a programme compatible with its mandate of keeping inflation close to target and maintaining financial stability might ultimately be decided by the risks to growth and to economic stability of the euro area.
Elsewhere, the Bank of Japan and the Swiss National Bank have already delivered some unconventional easing. The BoJ recently announced an intention to push the reserves in the banking system up by JPY 4 trillion, in addition to currency intervention. The SNB announced a similar desire to raise sight deposits from CHF 30 billion to CHF 80 billion along with a rate cut to stem its rising currency value.
For the EMs, non-traditional rather than unconventional: Non-traditional monetary policy has been the norm for so long in emerging markets that calling many of these measures unconventional might be considered a Freudian slip. Having said that, the surge of capital flows into emerging markets following QE2 did evoke a particular response from some of the leading EM central banks that we dubbed ‘QT’ (see Emerging Issues: QT, March 30, 2011). Specifically, the central banks of China, India, Russia, Brazil and Turkey aggressively used a combination of FX intervention and liquidity absorption in money markets via open market operations and required reserve ratio hikes to combat the build-up of liquidity in the money markets and the banking system. Unwinding QT would be an effective first step to roll back monetary tightening, in our view. More conventional policy rate cuts could follow, or could accompany the unwind of QT in a more subdued fashion.
Further, on the G10 periphery there a several central banks in DM which would be able to ease monetary policy meaningfully via the traditional tool, short-term policy rates, instantaneously. These are central banks that during the Great Recession either never got close to the zero lower bound for interest rates and/or have since been able to lift rates from the recessionary lows. Thus, the central banks in possession of ‘conventional’ ammunition are:
• The Reserve Bank of Australia: the next move of the Official Cash Rate (now at 4.75%, while the most recent trough was 3.00%) will be down, our RBA watcher Gerard Minack thinks; he now expects two 25bp cuts in 1H12.
• The Reserve Bank of New Zealand was forced to cut rates by 50bp due to the Christchurch earthquake, having previously increased rates by the same amount after the recession (current level 2.50%; recent trough 2.50%).
• The Bank of Canada, Sweden’s Riksbank and Norges Bank have all hiked rates and therefore have room to cut again should the need arise.
If worst came to worst, for each of these central banks rate cuts could be augmented by unconventional monetary measures – indeed, some of the central banks above did resort to unconventional measures during the Great Recession (see The Global Monetary Analyst: Global QE, Global Inflation, July 1, 2009).
Rewind the EM Policy Unwind
Absent a credit crisis or a housing crash, the EM world has recovered from the downturn much faster, creating a two-track global economy. As a consequence of that rapid recovery and a more recent duel with inflation, a significant portion of the monetary and fiscal easing delivered during the collapse of global growth and exports has been unwound. A conventional response to economic weakness might be to rewind some of the unwinding that has taken place. However, a mechanical benchmark of what EMs had done during the height of the crisis would be misplaced, we think. Many EM economies are still struggling to reduce their large budget deficits, and this means that fiscal expansion for the likes of heavyweights India and Poland can be practically ruled out. China’s fiscal position, even with the issue of off-balance sheet positions of local governments, is strong enough to provide selective fiscal stimulus via social spending programmes or measures designed to boost private investment (see Asia Pacific Economics: Implications from the Sovereign Debt Issues in Eurozone and US, August 9, 2011). On the monetary side, EM central banks have legroom to cut quantitative restrictions as well as policy rates, should the risk to exports and growth deteriorate markedly. This is likely the case even for countries like India and Brazil where inflation and overheating concerns have prompted an aggressive monetary policy response.
III. Will it Work?
Our short answer is yes. We believe that additional stimulus by the Global Central Bank will work, in the sense of making an impact on the real economy. There are several reasons for this:
• Channels of transmission: Unconventional policy has worked by flushing the system with liquidity to soften the impact of the informational problems that prevent borrowing and lending by supporting asset prices and raising inflation expectations. We are often asked whether QE will be successful only at raising asset prices and raising inflation expectations but not at supporting growth. In our opinion, once the monetary stimulus is successful in reaching the intermediate stage of affecting asset prices and inflation expectations, there is little reason to think that these intermediate variables will not have an impact on final spending. After all, higher inflation expectations imply lower real rates. The structural forces of deleveraging are relatively low-frequency headwinds and a renewed surge in asset prices and inflation expectations will outstrip these headwinds in the short run, in our view.
• Effectiveness of unconventional versus conventional easing: Unconventional monetary policy may in some cases be less effective, i.e., deliver less stimulus, than conventional measures. After all, one of the reasons behind certain central bank tools being ‘standard’ is maximum efficacy. Note though that this need not always be the case. First, the experience of the Great Recession shows that unconventional measures may be necessary to enable functioning of the ‘conventional’ channels in the first place; for example, when central banks provide liquidity directly to banks due to the interbank market – an important part in the chain of transmission for monetary policy – being frozen. Second, unconventional measures can augment the effectiveness of conventional tools. For example, rate cuts combined with direct purchases of long-term assets (i.e., QE) will lower long-term rates more than rate cuts in isolation would do.
• Timing: If the descent of the global economy into a renewed downturn is slow, there is a risk that the Global Central Bank will wait too long to deliver additional stimulus. This worry becomes all the more pertinent given the internal dissent in the various central banks (in addition to the persistent three-way split in the Bank of England’s Monetary Policy Committee and indications of disagreements within the ECB Governing Council, yesterday’s FOMC meeting revealed three dissenters).
• Fiscal policy: Ideally, monetary stimulus would be combined with further fiscal stimulus in order to maximise the impact on demand. In the major DM economies, however, the likelihood of substantial fiscal action is small. This means that – unlike two years ago – monetary policy is likely to have to go it alone this time around. Worse, there is a possibility of meaningful fiscal drag next year, resulting from the possibility of the payroll tax incentives and the Bush era tax cuts expiring in the US and fiscal tightening in the peripheral – as well as some core – eurozone countries.
In summary, the Global Central Bank can still deliver further meaningful monetary easing. For central banks that are effectively at zero interest rates, further easing would mean pushing a little further into unconventional territory. The Fed could push the interest on excess reserves into negative territory, or work with the Treasury to support the mortgage markets. If innovation in asset purchases is the need of the hour, then taking on positions in the interest rate swap market can lower long-term rates. The Fed can even pursue equity purchases should market conditions warrant such a choice. The ECB could turn more unconventional simply by mimicking the Fed’s large and unsterilised asset purchase programme. Emerging markets, having unwound the policy easing they provided in the crisis, could rewind some of this unwind and deliver a combination of lower required reserve ratios, rate cuts and fiscal easing where possible.
Source: Manoj Pradhan and Spyros Andreopoulos, Morgan Stanley, August 12, 2011.
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