First off, in our view QE has worked. What do we mean by "has worked"? QE, and monetary policy more generally, cannot deliver strong growth when the overhang of previous excesses still weighs on the economy. But it does support growth through supporting asset prices, increased inflation expectations and lower bond yields and spreads - and hence lower real interest rates (and weaker exchange rates). In addition, it satisfies the public's increased preference for safe and liquid assets (cash and central bank reserves). At the same time, it's probably true that there are diminishing returns to QE: the incremental easing achieved by each successive round declines, and so do the effects on the real economy.
But to answer the question properly - to understand why central banks keep doing QE - it is important to put oneself in monetary authorities' shoes and perform the same cost-benefit calculations that they are doing. It turns out that in the absence of other - more potent - policy tools, large real effects of QE are not necessary to induce central banks to engage in (further) QE. Given the potentially very serious adverse effects of deflation and the fact that central banks themselves view upside risks to inflation stemming from QE as small and manageable, then even very modest effects of QE are sufficient to justify it. Put differently, from central banks' point of view, the risk/reward of further QE remains very favourable, indeed compelling, in the current economic environment. When there are few low-cost tools available, and as long as QE can reasonably be expected to make a positive contribution - however modest - to keeping the economy away from the danger zone, monetary authorities are likely to continue deploying this tool.
Q2: QE has raised risks of high inflation, thus increasing inflation uncertainty. Has this not undermined investment and growth rather than supporting it?
There is no doubt that inflation uncertainty is harmful for investment and growth: inflation uncertainty creates uncertainty over the real return on investment projects; all else equal, this will crimp investment spending. We see three problems with this argument, however.
• First off, we question the premise: that QE has increased inflation uncertainty. We think it is even possible that QE has lowered, rather than increased, inflation uncertainty. As we have argued before, recent central bank policy, including QE, has mitigated - though of course not eliminated - deflationary risks. That is, while it is true that thanks to QE higher future inflation is more likely, it is also true that negative inflation is less likely.
But even if we grant that QE has increased inflation uncertainty, we think that the effects are more likely to be small - if not outright negligible.
• For inflation uncertainty to have meaningful harmful effects on spending requires much higher inflation rates than currently prevalent - empirical research suggests that inflation rates in the double-digits are required to produce meaningful effects on investment and growth. Now, it is conceivable that despite current inflation rates well below double-digit territory, expected price increases are very high - even though this is not what either market pricing or surveys of expectations suggest. But let's suppose for the sake of argument that this is true for a meaningful segment of corporates and households. The issue is that such a divergence between actual outcomes and expectations cannot last for long. If people learn, they will shift their expectations over time as the outcomes consistently prove their expectations wrong: a business person that expects 20% inflation but is confronted with outcomes in the 1-4% region year after year is likely to, sooner or later, change those expectations.
• Any uncertainty over future inflation is likely to be completely dwarfed by the uncertainty prevalent in the real economy. Whether compared to uncertainty over the future path of fiscal policy in some economies (e.g., US, Japan), elections and their outcomes (US, France) or geopolitical issues and the corresponding oil price volatility, the contribution of QE to overall macro uncertainty can only be very small.
Q3: Won't the large amount of excess reserves inhibit rate hikes and policy normalisation?
No. Technically, the level of the main policy rate and the amount of excess reserves (and hence the size of the central bank's balance sheet) can be kept separate. It is true that the prevailing level of the overnight rate is influenced by the amount of excess reserves; hence, too high a level of excess reserves in the overnight market would pressure the overnight rate down and away from the overnight rate target (which is the main policy rate). So, what the central bank needs to do is to make sure that there are not too many reserves in the overnight market. It can achieve this through a combination of draining operations and/or outright asset sales, and incentives for commercial banks to keep their excess reserves out of the overnight market. The latter can be accomplished by raising the interest rate at which the central bank remunerates excess reserves in tandem with the policy rate (indeed, the Fed for example anticipates that this interest-on-reserves rate will be its most important policy tool when it comes to steering the overnight rate (see Manoj Pradhan, The Global Monetary Analyst: ER, RR, IOR and RRR, February 17, 2010).
While for some central banks - notably the Fed - there may well exist a host of practical issues to be resolved in this context, we think that by and large central banks should be able to at the very least broadly steer the overnight rate to the desired level. Under this premise, central banks should be able to push borrowing costs and financial conditions in the right direction.
Q4: Why then do you still see inflation risks from QE?
As just explained, we think that central banks have the necessary tools to effect policy normalisation when they think the time is right. So, it's not the "tools" part that worries us, it's the "when they think the time is right". In our view, given the fragility of the economy and the possible adverse consequences of deflation, a rational central bank will want to err on the side of caution and exit too late, rather than too early (see Arnaud Marès, The Global Monetary Analyst: Better the Devil You Know, August 18, 2010). There are enough cautionary tales of premature exits in economic history (for the Great Depression see Spyros Andreopoulos, The Global Monetary Analyst: Back to the Future? September 14, 2011, and for Japan see The Global Monetary Analyst: The Mistakes of Others, November 9, 2011).
This insight applies to any kind of monetary policy tightening - QE or not. But in the case of QE, there is an added element. The large amount of excess reserves with the banking system provide an additional source of risk, as this is a variable over which central banks have incomplete control (see Manoj Pradhan, The Global Monetary Analyst: Reversing Excessive Excess Reserves, October 28, 2009). We have stated above that central bank control of the overnight rate requires incentives that commercial banks keep their reserves out of the overnight market. Yet, this does not guarantee that commercial banks will keep their reserves out of the real economy as well. Once the economy improves, commercial banks may find it profitable to use their excess reserves to lend to households or businesses (a risk that has been debated in the past by the FOMC for example). This would further increase the money supply, boost spending and raise inflation risks. That is, while central bank tools discussed above are likely sufficient to give them the necessary amount of control over the overnight market and hence the overnight rate, this, in isolation, is not enough. Unless, therefore, the Fed manages the timing of exit - including the reduction of excess reserves - perfectly, inflation could take hold.
Q5: What happens when the public loses confidence in central bank liabilities?
In response to the seismic shift in private sector risk-aversion the financial crisis brought about, central banks have deployed their balance sheets to cushion the blow to the economy. They have done so by taking the unwanted risk off the private sector balance sheet and replacing it with safe as well as liquid assets: central banks' own liabilities (see Spyros Andreopoulos, The Global Monetary Analyst: QE Coming of Age, February 1, 2012).
This is, in essence, a confidence trick. It works for as long as the private sector is willing to hold these liabilities - i.e., for as long as they are considered safe, which in turn depends on them being considered safe by everyone else. A central bank will, of course, never default on its liabilities - they can, after all, create unlimited amounts of it. But the ‘safety' property also depends on whether this asset is seen as a store of value, i.e., likely to maintain its real value - its value in terms of goods and services. So, while there is no technical limit to the expansion of central bank balance sheets, there is a limit nonetheless: the public's confidence in the real value of such liabilities - and government liabilities more generally. The more such liabilities are created, the more we approach this point.
How would such a loss of confidence unfold? If the supply of central bank liabilities - call it ‘liquidity' - exceeds the public's liquidity preference, then the latter will seek to substitute away from it. The public will then buy goods and real assets. The result is self-fulfilling inflation - inflation will rise essentially because the public has lost confidence in the ability of central bank liabilities to maintain their real value. We are probably very far from such an outcome - far enough that it can be considered a tail risk. Yet, the risk in question is nothing less than a wholesale run on the fiat money system.
The risks to our ECB call for 50bp of further rate cuts and outright Quantitative Easing (QE) in 1H12 have increased markedly in recent weeks. Euro area money markets have essentially priced out all ECB easing this year. The monthly ECB press conferences have become increasingly upbeat. Financial markets for risky assets have experienced a sharp rally in early 2012, fuelled by actual and expected LTRO liquidity. Business sentiment, at least in the core countries, appears to be stabilising. Globally commodity prices are on the rise.
As a result, we now expect only one more rate reduction of 25bp from the ECB in 2Q12 and view outright asset purchases, i.e., QE, as a backstop if the financial-cum-sovereign crisis unexpectedly worsens again. Previously, we had penciled in 50bp of rate cuts in 1Q and the start of QE in 2Q. At the end of the day, the course of policy action in Frankfurt will very much depend on whether the two three-year LTROs are able to stabilise the financial system sufficiently over the medium term. Hence, the market reaction once the second LTRO is out of the way and the new funds have trickled through the system will be key. In this context, we will be keeping a close eye on the availability of bank loans to the private sector, notably to non-financial corporates.
Clearly, the first two ECB press conferences in 2012 were less dovish than expected (see ECB Watch: Waiting for Next LTRO, February 9, 2012). In January, the Governing Council spoke of a tentative stabilisation and in February it no longer saw substantial downside risks to the growth outlook. While we agree with this assessment, we feel that it only means that the marked downside risks that were present in late 2011 have declined. Alas, the euro area as a whole is still in a mild recession and the periphery is mired in a very deep one. At the upcoming meeting on March 8, we would expect the ECB staff projections to be revised down meaningfully from the December estimate, which showed an average GDP growth rate of 0.3% in 2012. The new ECB staff projections should put the midpoint of the forecast range close to our own 2012 forecast of -0.3%, we think. Normally such a downward revision to the growth estimate would shave about two-tenths off next year's inflation projection. However, at this point, a higher oil price trajectory - which should be almost 10% higher than in December even after accounting for the stronger EUR - is likely to partially offset the downward pressure on the 2013 inflation projection from its December forecast of an average 1.5%.
True, there are signs of a tentative stabilisation in activity. But, so far, the stabilisation is only visible in the sentiment data, which seem to be stabilising at somewhat suppressed levels. Hard data such as industrial output, retail sales, car registrations, merchandise exports, credit growth or the labour market are not showing much of a stabilisation yet. And new risks to growth, including oil prices at new highs and a stronger-than-expected euro, seem to be building already.
A closer look at business sentiment indicators shows that it is mostly the expectation components that have started to improve, reflecting a rebound from the very depressed level at the height of the confidence crisis triggered by last summer's policy errors, notably the Greek PSI. The most recent crop of euro area business surveys shows that our surprise gap moved into the acceleration camp and our business cycle compass into recovery mode in February.
Closer inspection shows, however, that this is due to the increasingly gloomy expectations of manufacturers not coming to fruition. Company captains are revising their outlook for the next three to six months a bit higher, but still see the outlook below trend. Other key indicators such as order books, inventory levels and current output are at best hovering sideways at below their long-term averages. And, if it wasn't for the more upbeat mood among German manufacturers, the stabilisation for the euro area as whole would occur at a much more subdued level. In addition, we have consistently seen over the past few months that actual industrial production dynamics are falling short of our manufacturing production indicator estimates.
What's more, manufacturing is essentially the international part of the euro economy, which should be less affected by tightening fiscal policy and credit conditions - which alongside higher energy prices are squeezing domestic demand. (Note though that the manufacturing eurozone data also pick up intra-EMU trade.) As the fiscal policy stance for this year is largely set (with the exception of Spain, where the budget will only be presented in late March), the main swing factor for domestic demand is the availability of credit to the private sector, notably non-financial corporates. In this context, the last several sets of monetary data were rather disconcerting, given the sharply negative credit flows observed during December and the absence of any meaningful credit flows in January. While it is probably too early to expect the full impact of the LTRO and the wider collateral pool to be reflected in these data reports, it is worth bearing in mind that successful LTROs are only a necessary condition - and not a sufficient condition - to avoid a full-blown credit crunch in the euro area.
As long as the two three-year LTROs do the trick, there does not seem to be a need for the ECB to contemplate outright asset purchases, i.e. QE, which would also be highly controversial on the ECB Governing Council, we think. It is important, though, that investors are aware of the different mechanics of the LTRO as a form of indirect QE via central bank lending operations and active QE via outright asset purchases. The two are somewhat similar at first sight, as both boost the central bank's balance sheet as well as excess reserves in the banking system. But there are two key differences:
The first concerns the transfer of financial market risk. While under a QE programme the market risk is transferred from the financial sector to the public sector, this is not the case under a collateralised lending programme, such as the LTRO. Consequently, QE is a proper market backstop. An LTRO, by contrast, is not a circuit breaker. On the contrary, if we see the euro area banking system increase its sovereign exposure markedly on the back of the three-year LTROs, the circular connection between the banks and the sovereigns would become even closer than before.
As a result, another policy mistake, such as a repetition of the PSI, say, in the case of Portugal, could have even worse consequences than the Greek PSI decision. Back in 2009, euro area banks also used the LTROs to fund carry trades, and between October 2008 and October 2010 they bought nearly €480 billion of government bonds. Some of these institutions may later have regretted getting into the carry trade, particularly when the EBA announced a special sovereign stress test last autumn and equity investors became concerned about the sovereign exposure of European banks in the second half of last year.
The second important difference concerns the risk of potentially crowding out traditional bank lending channels. Given the attractiveness of the carry trades, notably in the sovereign space, and their powerful impact on bank earnings, we see a risk that the LTRO liquidity could be diverted away from lending to small and medium-sized enterprises and households. Admittedly, widening in the collateral rules regarding credit claims was intended to offset this tendency. But, it is important to bear in mind that, whereas under outright QE a bank would find itself with free cash sitting on its balance sheet that it can either deploy or give back to investors, this is not the same for central bank lending operations, which work via the liability side of balance sheet.
Efficacy of QE is undermined because of the effective subordination of private sector bond investors in the SMP. While these concerns lead us to believe that the two three-year LTROs cannot be a substitute for QE by the ECB, we need to acknowledge that the decision by the Eurosystem to effectively adopt a senior status vis-à-vis private sector bond investors will likely also have undermined the effectiveness of any outright asset purchases in the future.
True, there are two mitigating factors:
1. The Eurosystem will disburse any potential profits from its Greek bond holdings to the respective national governments, which are then earmarking them to contribute to making Greece more sustainable.
2. The fear of subordination only matters materially in those cases where the sovereign debt burden is viewed by the market as being unsustainable. Given that we would expect any QE programme to involve pro rata purchases of all countries, the largest chunk of purchases would likely occur in the core countries where such considerations should not play a great role.
But the fact that the Governing Council appears to have taken a decision to swap the ISIN codes for its Greek bond holdings and thus avoid being potentially hit by the CACs introduced by the Greek government last week suggests to us that a QE programme is not very high on the agenda for the ECB Governing Council at the moment. So, let's hope that the need for additional policy insurance against the risks of very deep recession and the resulting deflationary pressures in the euro area does not arise.
In with LTRO and QE3, Out with Funding Risks?
The depth and duration of risk-aversion have been a key risk for Indonesia, given the implications for currency, liquidity, sentiment and capital spending. Indeed, Indonesia has one of the highest total and short-term external debt to FX reserve ratios in AXJ, and high foreign ownership of government bonds means Indonesia is vulnerable to capital outflows.
We have argued that better macro fundamentals compared with the past, in the form of high foreign reserves, would help Indonesia to withstand ‘sudden stops in capital flows', but only up to the point before which risk-aversion gets sharp and prolonged. Indeed, amid the 2H11 sell-off, foreign reserves fell from US$124.6 billion in Aug-11 to US$110.1 billion in Dec-11. Foreign ownership of government bonds fell from a peak of 36% in mid-Sep-11 to 29.6% in early Dec-11, and Bank Indonesia (BI) intervened, increasing its stock of government holdings by US$3.4 billion since Aug-11, raising ownership share from 5.1% to 9.1% of total outstanding by Jan-12. However, as risk-aversion lasted for longer, the relative performance of IDR, a barometer of confidence, began to give way despite the sturdy performance at the outset.
From Funding Risks to Inflation Risks - A Flashback to Early 2011 Post QE2?
Now, with Global Monetary Policy Easing Part 2 (GME2) under way, falling Libor-OIS spreads reducing downside risks to global growth and the prospects of QE3 pushing up commodity prices, funding risks have given way to inflation concerns. To be sure, recent headline inflation in Indonesia has been depressed by high food prices from bad weather a year ago, and we are expecting a cyclical rise in headline inflation in 2Q12 as base effects peter out. However, amid aggressive easing by BI, potential rollback of fuel subsidies and GME2, inflation concerns have built up.
Some clients have asked whether recent inflation concerns in Indonesia could be a scare and inflation might turn out to be well managed as in 2011. Despite inflation concerns in early 2011 amid QE2 and bad weather, inflation ended the year at 3.8%Y, below BI's inflation target range of 5%+/-1%. We are believers in Indonesia's story of a structural inflation decline. But even then, the extent of deceleration caught us by surprise as a combination of structural factors, currency appreciation and luck (as food prices normalised) led inflation to fall.
Hence, in this note, we address the following questions:
(1) What are the key inflation drivers in Indonesia? Where are the key risks?
(2) Structural forces are benign for inflation, but if BI continues to test the boundaries of monetary policy easing, could cyclical inflation pressures take hold and overwhelm the structural downward forces?
(3) What is the inflation trajectory going forward? Inflation would surely rise from an artificially depressed level, but at what level does it start to become a concern?
Q1: What Are Key Inflation Drivers and Where Are Key Risks?
Watch the Three ‘Cs' of Currency, Commodities and Capacity Utilisation for Inflation Outlook
In our view, the three ‘Cs' of currency, commodities and capacity utilisation are key inflation drivers to watch in Indonesia. Historically, currency and commodities have been bigger drivers of inflation than capacity utilisation/output gap. Growth slowdowns in 1998, 2005/06 and 2008/09 were accompanied by high inflation due to currency volatility and/or commodity price adjustments such as in retail fuel or food. In other words, the Philips Curve - which dictates an inverse relationship between unemployment rate (read: output gap) and inflation - does not hold for Indonesia, in the presence of other more significant factors.
Indeed, this tends to be true for emerging market (EM) economies generally. Poor balance-of-payments (BoP) figures and a large share of foreign borrowings (a consequence of ‘original sin') typically debilitate the currency alongside weak economic growth. Moreover, high capital account convertibility accentuates currency volatility, as locals are able to switch between rupiah and dollar deposits. The lack of domestic confidence in the currency or a history of hyper-inflation also means a high level of dollarisation, which exacerbates the import-led inflation. Meanwhile, commodities such as food and fuel are a bigger part of the CPI basket in EM, and prices across a broad range of commodity segments rising on the back of supply/demand shocks and the commodity super-cycle in the past 10 years have added to inflation pressures.
Specifically for Indonesia, retail fuel prices are not marked to market. This means that energy inflation does not flow through the system gradually but comes in spurts when prices are adjusted on an ad hoc basis, e.g., by 249% in 2005 and 33% in 2008. In some cases, retail fuel subsidies amid surging oil prices may also have contributed to currency vulnerability as the oil trade deficit widened on the back of arbitrage activities and the current account balance dipped into deficit position, e.g., in 2005 and 2008. The reverse could also be the case whereby currency vulnerability amid capital flight compounds pressures on fiscal balance sheet, leading to an unwinding of fuel subsidies, e.g., in 1998. Meanwhile, Indonesia's status as a food producer has not guaranteed low food inflation. A protectionist stance towards farmers means policy-makers have been traditionally less keen to use trade channels to vent price pressures from local supply shortfalls.
Improved Currency Stability to Drive Structural Inflation Downtrend...
Going forward, amid the improved macro fundamentals and balance sheet (reduced external debt ratios compared with before) and generally higher foreign reserves, currency volatility is reduced, and the vicious loop of currency volatility leading to higher inflation should now work in reverse. Better currency stability should help to drive a structural inflation downtrend of lower lows and lower highs, via less import-led inflation and better anchoring of price expectations. This is the central tenet of the ‘structural Goldilocks' story which we envisage for Indonesia.