Over the past month the central bank ‘put’ is firmly back in play, triggering a global rally in risk assets. Thus Fed rate hike expectations have been broadly pushed into the new year, with some even beginning to speculate about incremental easing rather than tightening. The European Central Bank (ECB) has fuelled expectations of additional easing over and above the current program by committing to a relook in December at its existing policy accomodation. Speculation has started that ECB may cut deposit rates further into negative territory and / or make the asset purchase program more explicitly open ended. China has cut deposit, lending and cash reserve rates again after its first sub 7% quarterly GDP reading since 2009. And speculation is strong that the Bank of Japan (BoJ) may add to its own asset buying program sooner rather than later with the Japanese economy flirting with a technical recession.
What has to stand out here is that seven years into an unprecedented global monetary policy response led by the Fed, growth and inflation still need more support. Meanwhile the super-conducive global financial conditions of falling rates, rising equity prices, and depreciating developed market (DM) currencies helped sustain a massive leverage cycle in emerging markets (EMs). The premise always was that either continued easy policy would sustain ad –infinitum (nauseam?) or it would generate growth and inflation that would make future servicing of this debt effortless. As it turned out, both premises have faltered: Although aggregate central bank easing indeed seems to be ad – infinitum, the expected divergence in policy path of the US versus other majors has created massive cross currency volatilities and capital reallocations, which has severely dented debt servicing capabilities (for more on this please refer our note “On Global Macro-Dynamics: The Pressure Valve”, dated 5th October). More fundamentally, the lack of growth and inflation is a serious impediment to sustenance of this leverage cycle as debt servicing ultimately needs revenue growth whether one is a company or a country. An added dimension of this unprecedented easing has been the hit to savers in terms of interest income foregone and the added concern with companies in terms of servicing future pension liabilities.
Financial Conditions: Staying Still Is No Longer Enough
An additional concern is how major central banks engaged in competitive easing are losing control over their local financial conditions. For the sake of simplicity one can assume that interest rates (including term spreads and corporate spreads), equity prices, and exchange rate are the three pillars that largely determine local financial conditions. Thus financial conditions for a local economy tighten or loosen depending upon directional changes in these variables. It is also true that incremental changes to these conditions are mostly happening via the exchange rate route. This is because rates are mostly already towards the zero bound (of course central bankers can influence term and credit spreads via expanding their asset purchases but incremental benefits in this regard are not as strong) while equity prices are not directly controllable by central banks. What remains hence is relative currency depreciation via balance sheet expansion; though no central bank will explicitly mention an intent to move its currency even though the drag to growth and inflation from a stronger currency may still be acknowledged. In a world where the global ‘stock of growth’ is no longer rising and productivity expansions are harder to come by, a rough and ready way to allocate someone else’s growth to yourself is to simply price your goods and services cheaper via a cheaper currency. And hopefully, rising import costs (which also come with a weaker currency) will help lift inflation a little and , again hopefully, maybe even inflation expectations over a period of time. It is another matter that the evidence on this so far is that such boosts are at best of a temporary nature.
Looked at from this lens of financial conditions, the dilemma faced by the world’s major central bankers is readily visible. The US Fed has basically been standing still for some time, in that it has stopped incrementally expanding its balance sheet via additional asset purchases, stopped cutting rates, and is now looking to administer modest hikes in its policy rate which will still keep overall monetary policy quite loose. This would make sense ceteris paribus, or keeping all other things unchanged. But the truth of the matter is that all other things are not unchanged. In the time that the Fed has been standing still, ECB and BoJ have embarked upon additional easing. This has caused relative strengthening of the dollar over the past couple of years. Of course the trend has been helped along by some global capital allocations returning to dollars purely because the Fed has stopped the incremental printing press. No doubt the emerging market stress exposed in a commodity downturn has also helped this phenomenon. But the point here is that even as the Fed has stood still and done nothing to incrementally change financial conditions in the US, US financial conditions have nevertheless tightened. For all its ‘bazooka’, for the past six months or so the ECB seems to be running to just stand still if the movement in the euro is any indication. In fact the progression in this ‘musical chairs easing’ (not our words) seems to be thus: Local financial conditions ease on the back of incremental central bank easing led by currency weakening, thereby allowing ‘snatch back’ of some growth and inflation. This very economic data then leads to relative currency appreciation and rise in bond yields (and hence tightening of financial conditions) which leads the central bank to start all over. The most dominant example of this is potentially the Fed, which started the earliest and in the most aggressive fashion down the path of monetary easing. In contrast the ECB and the BoJ were much more tentative at first, with the former even hiking rates before having to go back on that. So through the first phase of the last seven years post the global financial crisis, the US led global policy easing in an unequivocal fashion. Therefore, it got its rewards earlier as well in terms of growth stabilization. On the back of this relative stabilization, markets started pricing the dollar and US yields higher relative to other major markets. This has caused a progressive tightening of US financial conditions over the past couple of years or so. Arguably, this tightening is now beginning to show in US economic data thereby prompting the Fed to push against this tightening by delaying rate hike expectations. The problem, of course, is that if the ECB and BoJ may ease policy further in the next few months, then relative financial conditions in the US may continue to be tighter unless the Fed does something more explicit. Alternatively, the expectation unwind may be enough to start sending the dollar lower which in turn may eventually invite more aggressive easing by the other two central banks.
The game of musical chairs of DM policy easing, aptly described so by our own RBI Governor, is unlikely to add to the net ‘stock of global growth’. This is because any stability to near term growth and inflation prospects is being achieved via influencing relative financial condition; which broadly only redistributes the existing stock of growth. Whereas, the underlying problem seems to be more of capital misallocation over a long seven to ten year cycle. Throwing more capital at the same ‘old economy’ is progressively reducing the incremental efficiency of capital with the result that more number of units of capital are now going in to produce one unit of growth. Furthermore, while asset owners have been benefited by quantitative easing, income earners have been hit; and quite severely. This is one probable reason why the consumption stimulus expected courtesy lower oil prices hasn’t been fully forthcoming.
The other problem, which tells also to the difficulty that the Fed faces in actually starting to raise rates, is that one’s local financial conditions are not being determined only by local monetary policy but by that being followed by others. So if one were to imagine a central bank as having a ‘financial conditions target’ consisted with its assessment of local growth and inflation prospects, these conditions are continually changing basis what other central banks are doing. EM issues get periodically thrown into the mix via external account, commodity dependencies, or political uncertainties. This further changes financial conditions, thus keeping DM central banks on a perpetual monetary treadmill. And so long as this continues, we are probably only continuing to extend this already long cycle of global capital misallocation.
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