If it ain't broke, don't fix it: Committing to a particular path for policy rates is not a new strategy. The BoJ (2001) and the Fed (2003) used it explicitly when they committed to keeping policy rates low to fight deflation and the prospect of deflation, respectively. Even back then, the commitment to low policy rates was conditional on the outlook for the economy and prices. This time round, the conditional time-commitment tool used to fight the Great Recession has the same look and feel. Central banks have used this tool to give markets a definite horizon over which rates would remain low, without making such statements on an unconditional basis.
Volatility as an instrument: The use of time commitment essentially serves to reduce the unpredictability around future policy rate decisions of the central bank. Statistically minded readers will naturally see this as an attempt to reduce the variance surrounding the path of policy rates, or to narrow the probability distribution around the expected path of policy rates. Since interest rates further along the curve depend on the expected level of shorter-maturity rates, providing a high level of certainty that the policy rate will stay low serves to more firmly anchor longer-maturity rates at low levels. Pulling yields lower all along the curve then transmits the monetary stimulus more efficiently into the real economy. In effect, what the central bank is thus doing by giving markets a time commitment is using volatility as an instrument of monetary policy. Of course, as we have seen over the past year, markets have questioned this commitment on several occasions, suggesting that the central bank only has partial control over volatility. It is interesting to note that such an objective could even be seen in the Greenspan Fed's actions when it telegraphed its incipient actions to the market in order to prevent surprises.
Did it work? We believe so. By making policy rates explicitly conditional on the need to provide policy support to the economy and the outlook for inflation, the time commitment given by central banks was able to reassure markets of easy monetary conditions for a significant period of time. Our opinion that this time commitment was indeed an explicitly considered unconventional tool, and an effective one at that, is ratified by the BoC's accolade that "this unconventional policy (of conditional commitment) provided considerable additional stimulus during a period of very weak economic conditions and major downside risks to the global and Canadian economies".
Similarities... The Fed, the BoC, the Riksbank and the RBNZ all gave a commitment conditional on economic conditions or inflation. The Fed's promise to keep rates "exceptionally low for an extended period" was employed because "economic conditions were likely to warrant" such low rates. The BoC's monetary policy statement said "conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010". The Riksbank's announcement to keep its repo rate at a low level until the beginning of 2011 was also conditional since its announced interest rate path is always conditional on the economic outlook and inflation projections, all of which are reported in its monetary policy statements. Finally, the RBNZ also committed to keeping its policy rate at or below 2.5% until the latter half of 2010 in order to provide "further policy stimulus to the economy". The implication being that the Official Cash Rate would move up when the need for such policy stimulus was no longer present. Besides the Fed, which introduced this commitment in December 2008, the other three central banks expressed their commitment in a synchronised fashion in April 2009.
...and differences: Central banks may have instituted these commitments at the same time and in the same spirit, but their approach to maintaining and withdrawing/fulfilling that commitment shows important differences. In our previous note, we argued that the duration for which the time commitment was shown could not be too small (lest it trivialised the issue because central banks in the G10 rarely reverse their policy stance very quickly anyway), nor could it be too large because then markets would focus predominantly on the conditional nature rather than the commitment. The BoC, the Riksbank and the RBNZ all provided specific points in time until which their rates were expected to remain on hold. All three have modified the timing of their exit before the self-imposed deadline, suggesting that perhaps the time horizon they adopted at the most difficult period of the Great Recession may have been just a little bit too long. On the other hand, the Fed has never made reference to any particular period until which its exceptionally low rates would be maintained. By remaining ambiguous, it has stopped short of giving markets a clear time period over which it would (conditionally) stay on hold, but has managed to avoid reversing its own guidance as well.
The RBNZ was the first to move (December 2009): While the BoC's recent change in language has garnered much attention, the RBNZ was the first of the four central banks to meaningfully use the commitment language to signal a change in its view. After introducing the commitment in April 2009 to keep rates at or below 2.5% until "the latter half of 2010", it used the December 2009 policy statement to shift the timing of its first hike to "around the middle of 2010" if the economy "continues to recover".
The RBNZ meets tomorrow morning, and we expect no further change on this front. Markets are correctly caught between expecting a first rate hike at its June and July meetings (10bp and 33bp, respectively, are priced in for those meetings, suggesting some chance of a 25bp hike in June, barring which a 50bp hike could happen in July). Our long-standing base case is for a first hike of 25bp in July with no hurry to rush rates back to ‘neutral' (see "On Different Sides of ‘Neutral'", The Global Monetary Analyst, April 7, 2010).
The Riksbank was next (February 2010): The Riksbank's April 2009 statement suggested only that rates would be kept "low" rather than at that level until the beginning of 2011. In its very next statement in July 2009, it firmed up the precision of its commitment after cutting the repo rate to 0.25% and committing to keeping it at that level until autumn 2010. This is the message that was reiterated all the way until February 2010, when the Riksbank revised the timing of its first repo rate hike to the summer or autumn of 2010. The accompanying policy statement was "the risk of a major setback in the recovery of the economy has declined and...the upturn therefore rests on more solid ground. There may thus be a need to adjust monetary policy to more normal conditions somewhat sooner than was assumed in December". The statement clearly suggested that the low level of the repo rate depended on the need to provide insurance against downside risks to growth and inflation. With a diminished need for such insurance, the need to keep the repo rate at near zero is clearly less pressing. Our Riksbank watcher Elga Barstch continues to expect a first rate hike in 4Q10.
And the BoC was the most dramatic (April 2010): The BoC was the latest central bank to modify its time horizon to signal an earlier-than-announced exit from its regime of extremely low policy rates. Almost exactly one year after it made its commitment, and just a couple of months before it was due to expire in-the-money, the BoC dramatically dropped the entire statement regarding its commitment to keep rates at 0.25% until the end of 2Q10 and made a pointed reference to it. The obvious implication that rates could be hiked before June is supportive of our Canada team's call for a rate hike in June.
The Fed leaves it late: And finally, almost as if it was a carefully scripted melodrama, the Fed is the last of the four to act. It has changed neither the "exceptionally low" nor the "extended period" phrases in its policy statements. But how does that gel with our US team's out-of-consensus expectation for a first rate hike in September? In his FOMC preview, our Chief US Fixed Income Economist David Greenlaw argues that Fed officials have recently pointed out the conditionality of the "extended period" language and also that the wording "extended period" does not refer to any fixed period of time. This suggests to him that Fed officials are aware of need for flexibility without dropping the "extended period" phrase. Our US team believes that the Fed would be best served by retaining the "extended period" phrase but dropping the word "exceptionally" in order to signal that policy will remain accommodative but that the policy rate need not be near zero.
Time to put the time-commitment tool back on the shelf? We don't think so. This policy tool is likely to retain an important role even once central banks start hiking rates. Not all central banks will take rates linearly back to neutral. Our US team, for example, expects the Fed to take policy rates up to 2% and then pause for a considerable period of time. In his FOMC preview, David Greenlaw also points out the possibility of a modest amount of sales of assets purchased during the QE programme. In both these situations, effective communication and providing markets with a credible commitment to not hike rates or sell assets rapidly should play a crucial role. We believe that central banks would do well to take a page out of the playbooks of the Fed, the BoC, the RBNZ and the Riksbank over the last year.
This time it's different. In virtually every post-war recovery, the US has led the global economy out of recession. But it is different this time: Asia excluding Japan, other emerging markets and their suppliers are at the front of the pack. In contrast, thanks to lingering housing and consumer headwinds, the US is somewhere in the middle. As a result, we think strong global growth will boost US (net) exports and add materially to growth in US output this year and next. Specifically, we think net exports will add about 0.3% to growth this year, in contrast with the typical drag on US GDP as imports rebound in recovery. Upside risks to non-US growth mean a larger boost is increasingly likely.
Two factors support that outlook: First, consumer and business demand in the rapidly growing economies have become key factors driving their growth. Our global team estimates that overall growth in China, India, ASEAN, Latin America and Canada will average about 8.3% this year and 7.0% in 2011. Growth in private domestic demand will likely account for between 65% and 95% of this growth, depending on the country. For example, Marcelo Carvalho just raised his 2010 outlook for Brazilian growth from 5.8% to 6.8%, with most of the boost coming from consumer and government spending. And our Asian team raised their outlook for ASEAN growth in 2010 from 5.1% to 6.1% (see "Brazil: Red Hot", This Week in Latin America, April 26, 2010 and ASEAN MacroScope: Cyclical Tide and Structural Disparity: Reviewing Outlook, April 28, 2010). Second, we project that US exporters will be increasingly leveraged to that fast-growing pie as their share of exports to those regions increases, especially in capital goods and consumer and business services.
Obstacles to improvement in net exports. To be sure, there are headwinds to the contribution to US growth from net exports. First, weakness in European and Japanese growth will likely hobble overall overseas demand. Most important, the sovereign credit crisis in the euro area means that even our tepid outlook for European growth this year of just 1%, with domestic demand contracting, is subject to significant downside risks as higher funding costs and fiscal austerity depress consumer and business demand. If the crisis escalates to curb the availability of trade credit, such impairment might further hobble US exports. In Japan, domestic demand is likely to be flat at best, while exports are the primary driver of Japanese growth. Another headwind facing US exporters is the lower price levels in many faster-growing economies; global consumers may be able to source many goods more cheaply at home. Finally, rising US imports might partly offset export gains in time-honored cyclical fashion.
Tailwinds: Asian (and Americas) consumers and a cheaper US dollar. We think two global tailwinds will swamp those headwinds. The share in US exports of goods and services delivered to Asia ex Japan, Latin America and Canada has risen significantly in the last decade, thanks in part to these countries' faster growth. Despite the global recession, the share of US goods exports going to those destinations rose from 69% of the total to 73% over the past five years, while the share of US services exports going to those economies also rose 4 percentage points to 46% over that period.
In addition, the dollar's ongoing decline on a real effective basis has given US exporters a competitive edge in those markets. Measured by the Fed's real effective trade-weighted exchange rate index relative to other important trading partners, the dollar has declined by nearly 18% over the seven years ended in March. At the same time, local currency appreciation in those fast-growing trading partners has improved their terms of trade, thus boosting real incomes and fueling their demand and import growth.
Empirical evidence in two forms. Statistical relationships illustrate these points. We estimated the parameters of a simple relationship to explain growth in US exports as a function of growth in non-US GDP, plus changes in the real exchange rate and non-oil imports (the last variable represents the influence of ‘round-trip' trade on exports). The estimated elasticity of real exports with respect to non-US GDP alone is about 2 - implying that, other things equal, 5% growth abroad will yield 10% growth in US exports. The elasticity of exports with respect to the real effective exchange rate implies that the 5% depreciation in the broad trade-weighted dollar over the past 30 months will add another 3.5% to exports. Those estimates are consistent with our view that US real merchandise exports will grow by roughly 10% over the four quarters of 2010.
Incoming data hint that our view of exports may be conservative. In March, the ISM export orders index rose to 61.5%, the highest level since 1989. If sustained, that level would be consistent with 13-15% real export growth, significantly higher than the 9.7% we expect for 2010. Non-defense capital goods orders and shipments are both up 7% annualized in the three months ending in March - which hints at strength in overseas deliveries of capital goods as well as domestic investment outlays.
Global capex revival? It's worth noting that global rebalancing of the sort we envision involves the potential for a significant upswing in capital spending, including in infrastructure, not just in EM economies but also in the developed world. As our colleague Joachim Fels likes to describe it, there is a lot of spare capacity, but it's in the wrong places and the wrong sectors.
That fits our script in three ways: First, an export-driven US recovery may require new growth in US supplying industries, including small and new businesses. Second, some of that investment will likely come in the form of foreign direct investment (FDI). Global investors will likely begin looking to strategic corporate US assets rather than our sovereign debt. Third, there is the time-honored ‘accelerator' mechanism: Global companies have reduced their older and less-productive capacity, and gross investment is rising simply to maintain the capital stock; in addition, they are replacing it with more productive capital. Those factors should benefit US capital goods producers exposed to global markets.
Import surge temporary. On the other side of the ledger, slower growth in US final demand seems likely to restrain imports. Imports have recently jumped, but we believe that much of the rise has reflected a significant swing in inventories as companies liquidated them more slowly. Between June 2009 and February 2010, real imports jumped by US$18.3 billion (16%), while the swing in real manufacturing and trade inventories (the change in the change in the stocks) was more than triple that magnitude (US$61 billion) over the same period. The magnitude of such changes likely will slow, as will the rise in imports.
Empirical evidence on imports supports that outlook. A simple relationship explaining the growth of real non-petroleum imports depends on the growth in consumer and equipment investment outlays, swings in inventories (which wash out over two quarters), the growth of exports (to capture and control for ‘round-trip' trade), and the real effective exchange rate. The elasticity of imports with respect to the domestic final demand components is 1.1, suggesting that moderate gains in demand will be associated with similarly moderate growth in imports. The model also suggests that the 5% decline in the dollar over the past 30 months will trim some 4 percentage points from what would otherwise be the growth in non-petroleum imports.
Criteria for sustainable rebalancing. In our view, this shift from US domestic to overseas demand marks the beginning of a long and beneficial process of rebalancing for the US and global economies. Ultimately, as noted above, it involves a shift in production venues through FDI back to the US, which has become a relatively cheap place in which to produce.
The biggest risk to this outlook is that contagion from the sovereign credit crisis would spread from Europe to other markets and economies. While our baseline view is that the combination of IMF and EU assistance will buy time for the peripheral economies in Europe to regain market confidence and implement aggressive fiscal restraint, that outcome is far from clear to us.
More broadly, three policy initiatives are critical to assuring the sustainability of US and global rebalancing: Fiscal exit in many developed market (DM) economies is needed to reduce the internal gaps between saving and investment that give rise to external imbalances. Improved exchange rate flexibility in the EM world, paced by the likely revaluation of the Chinese renminbi this summer, should facilitate the adjustment process and serve as an adjunct to monetary policy in Asian and Latin American economies where inflation risks are rising. And preventing protectionism from shutting markets should foster increased confidence that the benefits from globalization will outweigh its adjustment costs.
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