‘Strategic complementarity' - an enhanced willingness to ease if others do the same - makes such a G7 coordinated move easier to execute. A similar complementarity exists among EM central banks. The recent pre-emptive (and prescient?) rate cuts by the central banks of Turkey and Brazil make monetary easing by other EM central banks less surprising and therefore that much easier. To be sure, if DM central banks do engage in concerted action soon to tackle the problem in their own backyard, EM central banks will have less to do by way of easing to address weakness in external demand. However, if the central banks of the advanced economies continue to delay further easing, EM central banks could end up following the trail blazed by the central banks of Turkey and Brazil.
Chances of a coordinated monetary easing are rising: When we cut our global growth forecasts three weeks ago (see Global Economics: Dangerously Close to Recession, August 17, 2011), we warned about a negative feedback loop between weak growth and soggy asset markets in Europe and the US. Recent events have confirmed our fears: major equity indices have fallen further, peripheral European bond markets have continued to weaken, and key economic indicators such as US payrolls and the German Ifo business climate have surprised on the downside. Usually, to break such a negative feedback loop, a policy response is required. Yet, with fiscal policy in the US and Europe paralysed, all eyes are on the central banks. In our view, if financial markets continue to deteriorate, the chances of a coordinated monetary policy easing in developed economies are rising, perhaps as early as this weekend when G7 finance ministers and central bank governors meet in Marseille.
Fiscal gridlock in the US puts pressure on the Fed to act: Ideally, as fears about fiscal tightening in the US and Europe have been an important driver behind the drop in both market sentiment and business and consumer confidence, a swift fiscal response would be the first-best solution to stabilise the economy. In the US, we believe that the first-best solution would consist of an extension of, and possibly additional, fiscal stimulus into 2012, coupled with a credible gradual medium-term deficit-reduction plan. While President Obama looks set to propose additional stimulus measures this Thursday, our US team believes that the address will likely merely serve as a recommendation for the so-called Super Committee that won't present encompassing fiscal proposals until late November, which then have to be voted by Congress in December. The likely fiscal policy gridlock puts pressure on the Fed to stabilise markets and the economy.
A European fiscal solution will likely take time, putting the ECB centre stage: In Europe, we believe that the first-best solution to the sovereign debt crisis is a fiscal one - as opposed to the two other possible solutions, monetisation or euro break-up. ‘Fiscal' in this context means some form of fiscal transfer mechanism or insurance scheme by the stronger countries for the weaker ones, in return for a credible commitment to respect fiscal rules, underpinned by transfer of fiscal sovereignty to a European authority. A ‘fiscal' solution of some sort is still the most likely outcome eventually, in our view. However, to get there, economic and market conditions will probably have to get a lot worse than they already are as Germany and other core countries need to stare into the abyss of ‘monetisation' or ‘break-up' before they agree to write the proverbial cheque. Looking at it this way, bad news on markets or the economy, especially in the core countries, is good news because it brings us closer to a lasting solution. However, it is unlikely that the fiscal solution materialises in the near term, which places the burden of keeping markets and the economy supported squarely on the ECB's shoulders.
Alas, both in the US and Europe, there are some domestic obstacles to rapid and substantial monetary easing. The Fed is facing internal opposition from three hawkish FOMC voters and political headwinds from conservative circles that oppose ‘money printing'. Also, with core inflation having trended higher back towards the FOMC's comfort zone, the case for large-scale balance sheet expansion is less clear than a year ago when core inflation was heading south and inflation expectations needed to be propped up. The ECB Council probably fears that a quick U-turn on interest rates would be seen as caving in to government pressures, which could tarnish its reputation and support from an already sceptical public in the core countries. And we think that the Bank of England's MPC probably harbours concerns that further easing, together with persistently high headline inflation, will foster expectations of higher inflation.
Strategic complementarity makes coordinated easing easier: Given these domestic concerns and obstacles, coordinated monetary action to stem a common problem - the mutually reinforcing loss of economic and market confidence - would be easier to justify than individual moves at different times. This is what we call ‘strategic complementarity' - the willingness and ability of each central bank to ease is higher if others are willing to move at the same time. A coordinated move - the first since the coordinated post-Lehman rate cut by seven major central banks (see Global Economics: The Great Monetary Easing, October 8, 2008) - could occur as early as this weekend, when the G7 finance ministers and central bank governors meet in Marseille. Ahead of the G7 meeting, the ECB Council at its meeting this Thursday could pave the way for later, coordinated action by dropping its tightening bias, and adopting a more balanced risk assessment, based on a likely downward revision to the ECB staff's growth and inflation forecasts (due at the same time).
Coordinated easing could see a smaller set of actors and different actions: Back in October 2008, seven central banks - the Fed, the ECB, the Bank of England, the Bank of Canada, the Swiss National Bank, the Swedish Riksbank and the People's Bank of China - cut their policy rates by 50bp (the PBoC cut by 27bp). This time around, the players as well as the tools may be different. If there is a coordinated move, we expect the four major central banks - the Fed, the ECB, the Bank of Japan and the Bank of England - to participate. The Fed could cut its interest rate on excess reserves to zero and announce some balance sheet measures such as ‘Operation Torque', while the ECB could cut its deposit rate and/or the refi rate and announce additional term funding for banks. The Bank of Japan and the Bank of England could both respond with additional quantitative easing measures. These measures would be much easier to justify as part of a coordinated move rather than in isolation, in which case the threshold for each of these moves on an individual basis appears to be relatively high.
EM central banks have their own set of constraints: Having gone through a bout of overheating concerns with inflation just about peaking in the EM world, the traditional follow-up to the policy tightening of the last eight months would be to leave policy rates at their current levels for a reasonable period of time. Instead, global growth concerns have led markets to ask questions about how quickly policy tightening could be reversed. The message from most EM central banks is that policy tightening can indeed be reversed, but the need for such action is not evident yet. The implication is that domestic conditions are still the dominant part of the reaction function at this point in time.
Conveniently, the latest bout of DM weakness has come at a time when EM policy tightening has done enough to slow their economies down. PMIs in almost the entire EM realm have been falling for the last few months. The time for central banks to ease policies on the basis of domestic conditions is not here yet, however, because headline year-on-year inflation and sequential month-on-month inflation have not yet fallen to comfortable levels.
Cutting policy rates at this juncture is therefore a bet that global growth will fall enough to become a global disinflationary force. Given our own view that the US and euro area economies will likely come dangerously close to a recession towards the end of the year (see again Global Economics: Dangerously Close to Recession, August 17, 2011) and that their policy-makers face the kind of constraints we have discussed above, the possibility of just such a global economic environment becoming a reality cannot and should not be dismissed. The reluctance of not just DM but also EM policy-makers to take aggressive and/or pre-emptive action suggests that they will likely wait for the problem to actually confront them before they act. They will then have to act more aggressively than would have been the case if they had acted pre-emptively.
The risk/reward trade-off for taking out some insurance against a reluctant or weak policy response from the DM world could continue to shift towards the need for pre-emptive action. It is just such a risk/reward consideration that has likely prompted the central banks of Turkey and, more recently, Brazil to cut their policy rates.
Strategic complementarity exists in the EM world as well: The decisions by the central banks of Turkey and Brazil to deliver 50bp of pre-emptive (and perhaps prescient) cuts have attracted a significant amount of attention and questioning. Whether they will be proved right to pull the trigger remains to be seen but, at the moment, they provide two very important benefits. First, they provide a clear signal that these EM giants are willing to give centre stage to global growth concerns and buy insurance against what is already a significant risk of a DM recession and policy inaction. Second, they make rate cuts by other EM economies less surprising, thereby reducing the threshold for further EM easing in general. Policy easing by EM central banks thus generates ‘strategic complementarities' by making it easier for other EM central banks to follow suit.
There are already signs that some form of easing is either underway or in the works in some large EM economies other than Turkey and Brazil. In China, an income tax cut for individuals announced yesterday will deliver fiscal relief to the tune of 0.4% of GDP. On the liquidity front, the central bank cut reserve requirements for some banks in the Xinjiang province and for lending to SMEs. This is well short of a concerted monetary ease via RRR and/or policy rate cuts, but it highlights a mild easing bias that may already be in place. In India, inflation concerns could still produce a policy rate hike but RBI Governor Subbarao said yesterday that statutory cash reserves held by commercial banks were "high" and would be gradually reduced in order to boost lending and avoid a "crowding out" of the private sector. Finally, in Russia, fiscal policy is already expansionary in the run-up to the election towards the end of the year, making a reversal of the limited monetary tightening implemented by the CBR not as important as elsewhere.
Between DM and EM monetary policy, however, there exists ‘strategic substitutability': In simple words, strategic substitutability implies that EM policy easing will be less forthcoming if DM policy-makers respond aggressively. Growth concerns are rightly seen to be emanating from the US and euro area economies. Any action that will limit downside risks to growth in those economies, and therefore reduce the spillover to EM economies, will mean that EM policy-makers will have a smaller problem to contend with on the external demand front, in our view.
From a purely domestic perspective, EM policy easing is not necessary at the moment. Monetary easing via policy rate cuts by the AXJ giants China and India still seems some time away, given their struggles with inflation. For CEEMEA economies, slowing domestic growth and base effects leading to falling inflation would probably have meant rate cuts anyway, but these are likely to show up later rather than sooner. LatAm economies besides Brazil have already paused their rate hike cycle, but strong domestic growth and relatively high inflation means that rate cuts are not yet likely on the monetary policy agenda.
However, global risks will likely take centre stage as time goes by if policy-makers in the DM world only find convincing resolutions when they are staring into the abyss. To the extent that strong, coordinated and prompt monetary easing from the DM economies mitigates risks of a recession, we believe that EM central banks will have more legroom to focus on domestic demand conditions and inflation. If such action is not forthcoming, or if there are further policy errors, EM central banks would be better off acting pre-emptively.
Friday's employment report was much weaker than expected. After accounting for the impact of the Verizon strikers (-45,000) and the returning state workers in Minnesota (+22,000), payrolls rose only 23,000 - the smallest gain of the year. Moreover, there were sharp downward revisions totaling 58,000 in June and July. Hours worked and average hourly earnings were also disappointing in August.
We like to focus on the index of aggregate weekly payrolls - a comprehensive gauge that captures the impact of changes in employment, the duration of the workweek, and average wage rates. This measure declined by 0.4% in August, the sharpest drop since October 2009. If the household sector suffers a lack of income support due to a stagnant labor market, then consumer demand will begin to soften.
Most people don't realize how much churn there is in the labor market. Even in good economic times, roughly two million individuals are discharged from their jobs every month, and a slightly smaller number depart voluntarily. These job losses are generally more than offset by a somewhat larger number of individuals who start a new job (or return to a job they previously held). The recent deterioration in labor market conditions appears to be tied to a reduced hiring rate rather than a jump in layoffs. Jobless claims - a good proxy for the pace of layoffs - have actually been drifting steadily lower since May. So, with net job growth moderating quite bit relative to the pace seen during the early part of 2011, employers seem to have recently become more cautious about adding new workers or replacing the employees that are leaving. Unusually high levels of business cautiousness even before the intensified political and market turmoil in August were also seen in extremely low levels of net business investment in recent years. Even after a decent recovery in gross investment off the mid-2009 lows, net investment in 2Q was barely at replacement levels.
We suspect that this new-found reluctance to hire is probably attributable to an elevated level of business cautiousness in the aftermath of the debt ceiling debacle and ratings downgrade. Since 1978, the University of Michigan Survey of consumers has attempted to gauge the public's opinion about government economic policy. The results for August showed the greatest degree of pessimism in the history of the tally.
We continue to look for the shock to business and consumer sentiment in August to contribute to a prolonged period of cautious business hiring and investment and sluggish consumer spending growth. This was already seen in the apparent significant deceleration in business hiring rates in August. And while it has not shown up yet in consumption - August motor vehicle and chain store sales held up surprisingly well and 2Q consumption appears on pace for a moderate gain near +2% - the weakness in aggregate earnings in the employment report points to greater risks to income support for consumption going forward. As a result, we have trimmed our GDP forecasts slightly further, to +2.5% from +2.7% for 2H11 and to +2.1% from +2.2% for 2012 (on a 4Q/4Q basis), building in more sluggish consumer spending of +2% in 2H11 and +1.4% over the four quarters of 2012.
President Obama is slated to announce a major new job creation initiative at a joint session of Congress scheduled for Thursday at 7pm. Preliminary indications suggest that the president will propose an extension (and possibly an expansion) of expiring payroll tax cuts, a new jobs tax credit for businesses, unemployment insurance reform, new infrastructure spending, and possibly a foreign profit repatriation program. However, the reaction from Congress - especially the House - is likely to be less than enthusiastic. The key questions that one should be asking at this point are: a) will Obama propose anything that has a chance of getting enacted by Congress, and b) will he offer anything that can be done by executive order (such as streamlined refi)? We don't think that a major new jobs tax credit can pass the House, nor do we believe that the president is ready to implement a streamlined refi program. So, the address is likely to merely serve as a recommendation to the so-called Super Committee.
Coincidentally, that panel will start meeting this week, and one of the first orders of business will be a discussion of the scope of its responsibilities. Some members perceive the mandate to be very broad and are advocating measures aimed at providing short-run stimulus to the economy. Others feel that the Committee's duties are limited to identifying $1.5 trillion of budget savings over the next decade. If the members of the Super Committee cannot reach a compromise agreement or if Congress rejects the Committee's proposal, then automatic spending cuts go into effect in 2013. The deadline for the Super Committee to report is November 23, and if there is one thing we have learned from the recent budget battles, it's that these types of things always go down to the wire. Interestingly, November 23 is the day before Thanksgiving and thus falls immediately before the biggest shopping weekend of the year. Moreover, the deadline for Congress to act on the Committee's proposal is December 23 - just a couple of days before Christmas. Given what we know now about the degree of consternation in the general public surrounding the debt ceiling debate, you couldn't possibly pick worse dates to reignite political paranoia on Main Street.
Since the political environment in the US remains highly dysfunctional, the bulk of the president's new policy initiatives are likely to receive an unenthusiastic response from Congress. With the deterioration in labor market conditions in the US and the increased possibility that rising tensions in Europe could spill over to the global economy, there may be more pressure on the Fed to take action. While we remain skeptical that Bernanke and Co. will embark on a new program of asset purchases, an attempt to engineer additional monetary stimulus in the form of portfolio maturity lengthening and/or a further cut in the interest rate on reserves seems likely in the aftermath of the August jobs report. Indeed, at a minimum, it seems likely that the Fed will announce at the September 20-21 FOMC meeting that it will begin to concentrate its MBS reinvestments in longer-dated maturities.
The FOMC may also decide to gradually liquidate $150 billion or so of short-maturity Treasury coupons and reinvest the proceeds further out the curve, with an expected average maturity of about 10 years. By lengthening the duration of the System Open Market Account (SOMA) portfolio, the Fed would be trying to achieve lower borrowing costs for the private sector - particularly via the mortgage market. While some have called this an ‘Operation Twist', such terminology is not really appropriate because the Fed is actually trying to achieve a lower structure of yields across the curve. In contrast, the original ‘Operation Twist' exercise conducted in the early 1960s involved an attempt to push up short rates (in order to support the dollar) while depressing longer-term yields. We prefer to refer to the Fed's expected approach as ‘Operation Torque'.
In any case, we believe that the impact of a duration shift in the SOMA portfolio will be relatively modest. We also continue to anticipate that the interest rate on excess reserves (IOER) will be reduced to 0% later this year and thus expect the effective fed funds rate to hold near 0bp through the end of our forecast horizon in 2012. Moreover, if downside risks continue to materialize, we are intrigued by the idea that the Fed might eventually adopt a negative IOER along the lines proposed by Alan Blinder, in an effort to stimulate bank lending and/or securities purchases. Indeed, even the threat that such a policy might be implemented could have a potentially beneficial ‘unlocking' effect. With the 10-year TIPS yield having plunged to near zero, high long-term rates are certainly not restraining the economy. An extremely high liquidity preference by banks and other companies continues to stymie Fed stimulus efforts, so directly attacking this with penalty rates could prove effective.
As indicated above, we assume that the Fed will not restart large-scale purchases of Treasury securities - and even if it does, it probably would not have any significant impact on our growth or inflation forecasts. However, other more creative policy measures could have a meaningful impact on the outlook. In particular, we believe that efforts to unclog the mortgage refinancing pipeline would have the most bang for the buck. The Fed could help with such a program, but the Treasury would need to lead the effort. Unfortunately, recent indications from Washington have been that the White House may be backing away from implementing a major mortgage refi streamlining initiative.
The recent action by the Swiss National Bank to try to cap Swiss franc appreciation, continued the intensification of the pressures in European sovereign markets, and the worsening economic data in the US and other regions have begun to raise market expectations that there could be coordinated central bank actions. While the Fed is expected to announce implementation of Operation Torque at the upcoming FOMC meeting, it might be willing to participate in an earlier coordinated move. But the ECB still seems unlikely to implement the type of significant policy easing that would probably be needed as part of a major coordinated move. So, at best, we are likely to get baby steps. In particular, we may see the ECB cut the rate being offered on its weekly dollar liquidity auctions (currently an elevated 100bp over OIS). The dollar funding issues of European banks have been putting upward pressure on dollar/Libor rates, causing an unwelcome tightening of US financial conditions. A reduction in the premium at which secured dollar funding is offered to the banks would seem to be a relatively painless way to address these emerging liquidity strains.
Read Full Article »