Strategy & economics

The billion dollar question for central banks

28/01/2015

Janet Mui

Janet Mui

Global Economist

Here is the billion dollar question: what is the right policy response in an environment of lower growth and falling prices?

Prior to the latest development in the eurozone, we have already had plenty of examples from central banks around the world on how to address the question, although their actions may not have been optimal. The European Central Bank (ECB) has proved one of the more activist, albeit belatedly. It announced a near-open-ended quantitative easing (QE) program, buying public and private sector securities equivalent to €60 billion per month. In doing so, it joined the US Federal Reserve (Fed), Bank of England (BoE) and Bank of Japan (BoJ) in using alternative policy tools to supplement lower interest rates.

While the likely impact of QE on real eurozone economic activity is debatable, financial markets reacted favourably in anticipation of and to the announcement of QE. Eurozone equities have rallied, government bond yields have fallen further and the euro has slumped to the lowest in 11 years versus the US dollar. However, it has yet to be seen how effective eurozone QE will prove. All we have so far is ‘hope value’.

In the developed world, there is an emerging dichotomy in growth trends and the likely path of monetary policy. While the UK and the US are seeing above-trend growth, the eurozone and Japan continue to face stagnating economic activity and deflation. Domestically-generated reflation – through higher investment, productivity and wages – is crucial to economic sustainability. Moreover, in the eurozone and Japan, structural reform must be endorsed, with the dual objectives of creating more flexible labour markets and improved conditions for business. However, structural reform is often painful and can take years for the benefits to come through.

A weaker currency is the more visible channel through which looser monetary policy will work in an environment of zero interest rates and persistently subdued credit growth. Another immediate but more nebulous benefit is the confidence boost to financial markets and, to certain extent, businesses. Corporations with sources of revenue from overseas will benefit from favourable currency translation. A weaker currency is the ‘text-book’ definition of tailwind for exporters, but this will emerge only after an appreciable time lag. Even so, central banks are increasingly drawn to weakening their currencies by loosening monetary policy, if they can afford it. The ECB and BoJ are pursing the most aggressive version of this strategy, resulting in sharp depreciation of their currencies.

Unfortunately, this extreme loosening is contagious and potentially highly disruptive. The Swiss National Bank, for example, shocked markets by abandoning its costly peg to the euro, resulting in a rapid appreciation for the safe-haven currency and a commensurate decline in the Swiss equity market. Other ‘safe haven’ countries such as Denmark have been forced to cut rates aggressively to defend themselves against potential collateral damage from the euro.

Rate cuts have not been confined to ‘safe haven’ countries: oil prices have slumped over 50% since July 2014, and almost all developed economies face some degree of disinflationary pressure. The sharp fall in energy prices is proving to be a game-changer, forcing even inactive central banks such as the Monetary Authority of Singapore and the Bank of Canada to loosen policy. The Reserve Bank of Australia is the latest developed market central bank to cut interest rates, given its recent inflation profile and its status 
as a commodity exporter.

Emerging market (EM) economies with no inflationary threat and low external vulnerability can also afford to cut interest rates to boost growth. The impact of lower oil prices on headline inflation has allowed them more flexibility to ease monetary policy. These EM economies will also see less capital outflow if monetary policy is loosened. This analysis helps explain the surprise rate cuts by the Reserve Bank of India and Central Bank of the Republic of Turkey. Perhaps more importantly to the sentiment of global financial markets, the People’s Bank of China cut banks’ reserve requirement ratio universally for the first time in nearly three years, not long after the surprise interest rate cut back in November 2014. As nominal interest rates remain high and inflation slows in these countries, further rate cuts are needed to bring down the real cost of capital.

On the flipside, Brazil and Russia cannot afford any significant loosening in monetary policy, as their hands are tied by the turmoil in commodity markets, rising inflation and threat of capital outflow. Ironically, the Brazil Central Bank and Central Bank of Russia initially resorted to hiking interest rates just when their economies were facing the biggest economic headwinds.

In the current environment, (almost) every country wants looser monetary policy and a weaker currency, aimed at generating more growth from exports. However, the ‘competitive devaluation’ strategy will be progressively less effective if more trading partners do the same. The notion of ‘currency war’ first emerged when the BoJ pledged unlimited QE, and now there is rising evidence of this actually happening.

With the euro and the yen the second and third most traded currency globally, respectively, currency-focused monetary policy could prove increasingly divisive and potentially damaging for some economies. The removal of the cap on the Swiss franc and the huge losses made on euro positions show that central bankers are not infallible, and currency markets can move out of their control. We expect to see further volatility in currency markets in the year ahead.

Meanwhile, the Fed is ‘patiently’ waiting, still at the centre of the economic universe, leaving other central banks on tenterhooks. However, despite warnings from the Fed that it might begin tightening earlier than markets are anticipating, the surge in the US dollar may yet influence its thinking. There is emerging evidence from the fourth quarter earnings season that a strong US dollar has taken its toll on the profits of multinational corporations. Companies such as Caterpillar, Dupont, Microsoft, Procter & Gamble and United Technologies have warned they are facing headwinds in the year ahead from a strong US dollar. Historically, the Fed has tended to pay little attention to the fortunes of the dollar. More to the point, given the strength of domestic economy, it is likely to be the trend in wage growth that plays the greater role in determining when and how fast US interest rates start to rise.

This is also true in the UK, where the next step for the BoE is also likely to be a tightening in policy. But with headline inflation falling, markets have been extending the time horizon for the first change. What could force the Bank’s hand earlier than expected could be higher wage inflation; without this, members of the Bank’s Monetary Policy Committee will continue to look for excuses to delay the first step towards normalising monetary policy.

Ultimately, as central banks continue to loosen or remain on hold while they can, the US dollar is likely to keep strengthening. As countries attempt to ‘steal’ growth from each other, US exporters are paying the bill. Accordingly, we prefer domestically-oriented companies in our exposure to US equities. Elsewhere, we remain modestly positive in our stance towards European markets and emerging market manufacturers. On the other hand, although yields have continued to decline, we remain very nervous about the longer-term prospects for major bond markets. While we maintain our bearish medium to long-term stance on gold, we recognise that it may be attractive in the short term against the backdrop of negative real interest rates in many parts of the world and loosening monetary policy.

This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. 

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All data contained within this document is sourced from Cazenove Capital unless otherwise stated.

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