The euro is trading at its lowest level against the Norwegian krone since August 2015.  The euro is near its best levels against the Swedish krona in nearly as long. 

The euro is trading at its lowest level against the Norwegian krone since August 2015.  The euro is near its best levels against the Swedish krona in nearly as long. 

Through the first three-quarters of the year, the US dollar has fallen against most of the major currencies.  There are two exceptions.  Sterling’s story is Brexit.  The Swedish krona is the only other major currency that has fallen against the dollar (~2%).  In contrast, the Norwegian krone is second strongest of the majors, gaining almost 10% against the dollar (trailing the yen’s 18.7% gain).

The key driver is the divergence of monetary policy.  Sweden’s Riksbank has been and continues to be more aggressive the Norway’s Norges Bank.  Sweden has negative interest rates (minus 50 bp) and a bond-buying program.   As recently as this week, Riksbank Governor Ingves has signaled his intention to ease further.  Governor Olsen of the Norges Bank is moving in the opposite direction.  The monetary bias has shifted from easing to a neutral setting.

Sweden’s challenge is not growth.  The economy expanded 0.5% in Q2 for a 3.4% year-over-year pace.   Its challenge is not inflation.  Underlying inflation (not a core measure but uses fixed mortgage interest rates) stood at 1.4% last month.  It finished last year near 0.9% and was 0.4% at the end of 2014.   What the Riksbank seems most concerned about is that risk that it loses competitiveness against the euro as the ECB continues to ease.  Sweden’s current account surplus was almost 5% of GDP last year and is expected to be near 5.5% this year. 

Its budget deficit is around 0.5% of GDP this year, half of last year’s deficit.  When the IMF and G20 speak about countries with fiscal space, Sweden is often not mentioned.  This probably due to the relatively small GDP of around $550 bln. 

Noway’s macro performance lags behind Sweden.  The economy was flat in Q2, but excluding the North Sea, the mainland economy expanded by 0.4%.  Headline CPI was 4.0% in August. The underlying rate, which adjusts for tax changes and excludes energy, rose 3.3%.  Norway’s external account is driven by its petrol status.  It stands near 6.5% of GDP.  It runs a substantial budget surplus (~5.5% of GDP), but much reduced in recent years. 

The divergence has driven the Nokkie-Stockie cross significantly higher.  It is at its highest level since mid-2015.  At the start of the year the Norway at near SEK0.95.  It is making new highs today above SEK1.07.  A weekly trendline, going back to 2012 comes in above SEK1.0930, though falls toward SEK1.0870 by the end of the year.  The divergence could carry Nokkie through the trendline.  We look for a move toward SEK1.10-SEK1.12. 

Divergence: Norway and Sweden is republished with permission from Marc to Market

The post Diverging Global Monetary Policies Plod On appeared first on Economy Watch.

The Federal Reserve decided to leave its target interest rate unchanged at a range of 0.25 percent to 0.5 percent while suggesting a hike later in the year was very likely.

The Federal Reserve decided to leave its target interest rate unchanged at a range of 0.25 percent to 0.5 percent while suggesting a hike later in the year was very likely.

The Federal Open Market Committee (FOMC), which just concluded a two-day meeting in Washington, said a string of recent economic data show growth is picking up but not enough to convince a majority of its members to raise interest rates for only the second time since the global financial crisis.

“The committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.”

The FOMC’s so-called dot plot, which reflects its outlook for the path of monetary policy, shows that members still expect it to raise rates a quarter point in 2016. The committee meets next in November, but economists believe December is more likely for a rate hike.

We asked two scholars and former Fed officials – Mark Sniderman, an executive in residence at Case Western Reserve University who was chief policy officer at the Cleveland branch of the central bank, and Emory University’s Sheila Tschinkel, who was director of research in Atlanta – whether it was the right call.

The case for raising rates now

Mark Sniderman, Case Western Reserve University

Three Fed presidents dissented from the majority vote, an unusual event. These FOMC members clearly wanted to move the target rate up today, and, by dissenting, they are expressing the strength of their views.

I agree with the dissenters. However, before I get to that, two important points emerged from the FOMC’s statement. First, on a tactical level, the vote lays bare the strong differences within the committee regarding the timing of this rate hike. Second, and far more important, committee participants lowered their collective estimates of longer-term economic growth – from 2 percent per year to 1.8 percent – and, at the same time, revised down how much they expect interest rates to rise in the next few years.

My own preference, however, would have been for a rate hike now rather than later.

Viewed from a historical perspective, the case for a hike now is quite appropriate. The nation’s unemployment rate – at 4.9 percent – characterizes a labor market essentially at full employment. In addition, the core inflation rate – at 1.6 percent – is fairly close to the FOMC’s goal of 2 percent over the medium term.

In addition, most FOMC members expect the U.S. economy to continue expanding at a rate consistent with its potential growth rate. In other words, from a macroeconomic viewpoint, the economy is doing about as well as it can.

In situations like this, the FOMC should want to set its policy interest rate at neutral – the value it regards as neither encouraging expansion nor contraction. With the fed funds rate set at 0.25 percent to 0.5 percent before the meeting, the case for a rate hike was strong.

From a broader perspective, however, as long as the next rate hike occurs soon, the exact timing doesn’t matter very much. The dissenting votes indicate that there is internal pressure to move.

What should be most concerning to the public is the FOMC’s assessment that the economy is only capable of slow growth in the foreseeable future. If this view proves accurate, it is not the continuation of low interest rates we should be worried about but rather the slowing growth in our standard of living. That’s a problem monetary policy is not designed to solve.

Why the Fed’s right to wait

Sheila Tschinkel, Emory University

In its statement, the Fed acknowledged the case for raising interest rates has strengthened. This is good news because it means officials believe the economy is in good shape overall.

At the same time, real GDP growth so far this year has been steadily revised lower. In addition, estimates of future growth – along with the outlook for interest rates – have steadily tracked lower. In addition, there is no evidence that growth in consumer prices – inflation – is accelerating.

All of this means that the risks of waiting a little bit longer to raise interest rates are low. When the Fed does eventually act, if it turns out that the move is “late,” the central bank can always catch up by lifting rates by larger amounts or more frequently in the future.

The argument for increasing rates now so there is room to stimulate the economy if needed down the road (in case of recession) is a spurious one. Raising rates now would actually make such a downturn more likely, so creating the ability to respond to a self-induced recession is not a good scenario.

All the same, holding interest rates at such a low level for such a long time – it’s been almost eight years since the target rate was above 0.5 percent, which is unprecedented – no doubt creates risks. It pushes people into risky investments as they search for earnings, and it creates pressure on pension funds and the like.

There are negatives to standing pat, but raising rates right now and increasing the risk of slowing GDP growth is at least as negative, if not more so. There is a high risk that doing so would threaten job growth, just as people are finally returning to the labor force.

We need to remind ourselves that our expectations of what one macroeconomic policy tool – in this case monetary policy – can achieve are simply too high.

Was the Fed right to delay raising interest rates? Two scholars react is republished with permission from The Conversation

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Much of what the Bank of Japan announced today had been largely leaked.  While there was a sizeable response in the asset markets, the dollar’s knee-jerk gains against the yen were quickly unwound. 

The BOJ lifted its self-imposed restrictions on its asset purchases and shifted the focus of policy from the monetary base to the yield curve. It is not clear that this shift increases the chances of the BOJ reaching its inflation target. 

Much of what the Bank of Japan announced today had been largely leaked.  While there was a sizeable response in the asset markets, the dollar’s knee-jerk gains against the yen were quickly unwound. 

The BOJ lifted its self-imposed restrictions on its asset purchases and shifted the focus of policy from the monetary base to the yield curve. It is not clear that this shift increases the chances of the BOJ reaching its inflation target. 

Going forward it will implement its JPY80 trillion increase in the monetary base more flexibly, and will no longer have an average maturity target.  This produced a dramatic sell-off in JGBs.  Japanese bonds maturing in one to 15 years saw their yields jump 20-40 bp.  Longer-dated bonds rose less.  The 20-year yield rose 13 bp, and the 30-year yield increased by a dozen basis points.  The 40-year bond yield was practically unchanged. 

The BOJ also indicated it would stick with its JPY6 trillion a year purchases of equity ETFs, but changed the distribution.  It will buy more of the broader Topix.  Many participants had anticipated this, and there had been some outperformance of the Topix and the Nikkei 400 in recent days.  This continued today with the Topix and Nikkei 400 up 2.8% and the Nikkei 250 up almost 2%. 

The dollar initially fell to almost JPY101 before rallying to JPY102.80.  However, the enthusiasm was not sustained and the greenback eased back to JPY101.60.  It has been confined to about a 30-tick range in the European morning.  

Most Asian equity markets were higher, led by Japan.  The MSCI Asia-Pacific Index rose 1.4%, the biggest gain in two months.  European markets are also higher, with the Dow Jones Stoxx 600 up 0.6% in late-morning turnover.  Financials and telecoms are outperforming.

Attention turns to the Federal Reserve.  Most participants are convinced the Fed will not lift rates today, but will signal its intention to hike in December.  There is a meeting in November, but there is no precedent for changing policy so close to a national election.   

We try to be careful to separate what we think the Fed will likely do from what we think it ought to do.  We think the Fed ought to raise interest rates today.  In one stroke, it would recoup some of the credibility that critics say it has lost.  It would shift debate from over-promising and underdelivering to delivering a surprise.  We argue that the US economy is resilient enough to withstand a 25 bp rate hike.  In addition, contrary to some arguments that think the international climate is not supportive, we suspect that a Fed hike now would be welcomed by other central banks, which may have exhausted the political willingness to ease monetary policy further. 

In lieu of a rate hike, the dot plots and Yellen’s press conference will be the focus.  The FOMC finished last year saying that four hikes would likely be appropriate this year.  The dot plot, however, is not a commitment of promise.  Nevertheless, it shows how far the Fed was from the mark.  In June, it shifted to two hikes.  Now, if it is going to maintain that every meeting is live, it must signal a single hike.  The news stream could be a bit more supportive.  Following last week’s CPI and yesterday’s housing starts, the Atlanta Fed shaved its Q3 GDP tracker to 2.9%.  It will still be the first quarter in four that growth surpassed its trend of around 2%. 

A big (7.5 mln barrel) drop in US crude inventories is underpinning oil prices today ahead of the government’s estimate.  It appears to be lending support to the Canadian dollar, Mexican peso and the Norwegian krona.  Sterling remains out of favor.  It is the poorest performer over the past week, losing almost 2% and is spending more time below $1.30.  The low from last month was set near $1.2865 and in July just below $1.28.  The euro sold off after poking through $1.1210 yesterday.  It closed on its lows near $1.1150 and saw follow through selling to just below $1.1125 to match the late-August low.  Initial resistance is seen near $1.1160 ahead of the FOMC announcement.

BOJ Eases Self-Imposed Restrictions, but Can’t Weaken the Yen is republished with permission from Marc to Market

The post Maybe there is another Way to Weaken the Yen appeared first on Economy Watch.

The ultra-low and negative interest rate environment in advanced economies and its implications for the rest of the world are currently among the top concerns of financial market participants and policy makers worldwide. Mark Carney, the governor of the Bank of England, recently said the low interest rate equilibrium¹ is one of the challenges in which the global economy risks becoming trapped.

The ultra-low and negative interest rate environment in advanced economies and its implications for the rest of the world are currently among the top concerns of financial market participants and policy makers worldwide. Mark Carney, the governor of the Bank of England, recently said the low interest rate equilibrium¹ is one of the challenges in which the global economy risks becoming trapped.

The phenomenon started when the central banks of the Eurozone, Switzerland, Sweden, and Denmark adopted negative interest rates from mid-2014 to early 2015. Japan followed in January 2016 and Hungary was the first emerging market to introduce negative rates in March 2016.

The motives behind the adoption of negative interest rates differed among these central banks. The European Central Bank moved first in mid-2014 to counter a subdued inflation outlook, with the objective of increasing inflation expectations. The central bank of Denmark followed three months later. It maintains a nearly fixed exchange rate with the euro and had to intervene heavily in the foreign exchange market because of a surge in demand for the Danish kroner.

Negative interest rates have had the beneficial effect of reducing capital inflows in Denmark. Similarly, in Switzerland, pressure on the currency led the Swiss National Bank to cut interest rates after abandoning its Swiss franc ceiling. The goal was to discourage capital inflows and counter the monetary tightening from the strong franc. Switzerland has traditionally maintained lower interest rates than the rest of Europe, partly because of lower inflation and partly to fend off excessive capital movements.

Central Banks with Negative Interest Rates

EM = emerging market.
Notes: * The date added in parentheses is when negative policy rates were introduced.
** The number in red is the policy rate as of 16 July 2016.
Source: National central banks.

Sweden, as a small open economy, faced growing risks from a slump in the housing market and deflation caused by the drop in the oil price and global commodity prices. Adopting negative interest rates helped house prices to rise and, eventually, inflation is expected to increase toward its 2% target. In Asia, the Bank of Japan cut rates on excess reserves parked at the central bank to –0.1%, to counteract the effects of falling oil prices and the economic slowdown in the People’s Republic of China. Finally, Hungary cut rates to revive economic growth and fight inflation.

The response to negative interest rates from academia, market participants, and international organizations has been mixed. Supporters of negative interest rates² suggest they can be considered as another type of unconventional monetary policy. It should help to relax financial conditions (lower interest rates charged on loans) and deliver additional monetary stimulus by boosting private consumption and investment. It should also benefit borrowers by reducing their debt obligations, resulting in lower non-performing loans held by banks. In addition, although many have expressed concerns about the impact of persistently negative interest rates on the profitability of the banking sector, such an impact would depend on banks’ capacity to pass on the costs of paying interest on the reserves parked at the central banks through re-pricing of loans and deposits and other liabilities.

Recently, some critics³ assert that the impact of persistently negative interest rates on the profitability of the baking sector has emerged as an important consideration in Europe and Japan. Evidently, large banks in Japan have started to report a decline in profit after the implementation of the negative interest rate policy⁴. Another concern is that the profitability and soundness of institutions with long-term liabilities such as insurance companies and pension funds may be weakened. Also of concern may be the long-term effects of ultra-easy monetary policy, such as an over-reliance on monetary policy to boost economic growth and the resulting decrease in productivity growth⁵.

So what would be the main effect of the negative interest rates, if the real sector fails to absorb the benefits mentioned above? In many cases, the main effect is through the exchange rate channel. Negative interest rates help to weaken currencies through the capital outflow. This can be an attractive option for an individual country, but for the world as a whole, it can be a zero-sum game. Central bank easing could push volatile capital flows around the world. To the extent that it pushes greater savings onto the global market, the global short- term equilibrium rate would fall further, leading the global economy closer to the liquidity trap.

What would be the implications of the negative interest rates for Asia? It has long been argued that asset prices in Asian financial markets are influenced more by the monetary policies of the advanced economies than by their own policies and fundamentals. The recent work by the World Bank suggests that the implications of negative interest rate policy for emerging markets are mostly similar to those of other unconventional monetary policy measures¹. The low or negative bond yield in Europe and Japan, and the expectation of a slower than previously expected rate hike in the United States, has encouraged the search-for-yield behavior.

The resulting return of international capital flows to Asian bonds has boosted Asian currencies and pushed down yields on Asian government bonds. Consequently, emerging Asia may be affected disproportionately by volatile swings in international capital flows, currencies, and increasing external debt levels. The yield curves in Thailand and the Philippines have flattened, providing clear examples. In addition, volatile currencies and international capital flows, and higher asset price, have been common in Asia since the global financial crisis.

To help Asia address its challenge and to maintain its good performance in the global economy of which it remains the most dynamic part, it needs to harness its growth potential. Firstly, structural reform should be directly addressed on the supply side of an economy. It can help to reorganize an economy, as can be seen in the People’s Republic of China. Secondly, no matter how innovative monetary policy is, it can only boost growth in the short run. Monetary easing would have provided limited support to the economy and inflation, given the role of structural problems in the current global economic slowdown.

However, policy makers need to use the time bought by monetary policy to maintain growth momentum in the short run and address the near term risks (including the risk from high foreign exchange rate volatility and deflationary shocks). A flexible and proactive monetary and exchange rate policy is needed. If businesses and households have confidence in the long-term growth of an economy, it can enhance the effectiveness of a monetary policy stimulus. Thirdly, emerging Asia has macroeconomic buffers in its stimulus policy (fiscal and monetary policy). However, this should not make policy makers complacent. Structural reform of infrastructure, education, research and development, support for female workers, income inequality reduction, broadening the coverage of social spending, etc., is much needed.

The article is based on our presentation at the 5th OECD–AMRO–ADB/ADBI–ERIA Asian Regional Roundtable on Macroeconomic and Structural Policy Challenges, held on 14–15 July 2016 at ADBI, Tokyo, Japan.

Possibility of Cross-Border Spillover to Asia

US = United States; EU = European Union.
Notes: German government bond yield represents EU government bond. Yield curves were retrieved at the following dates for each period: Pre-crisis = 31 January 2007; Easing = 31 January 2013; Fed Hike Speculation = 31 January 2014; Current = 4 July 2016.
Source: Bloomberg.

_____

¹ Two other challenges are low inflation and low growth. From Mark Carney, “Redeeming an Unforgiving World” (speech given at the 8th Annual Institute of International Finance G20 Conference, Shanghai, 26 February 2016).
² Jose Viñals, Simon Gray, and Kelly Eckhold, “The Broader View: The Positive Effects of Negative Nominal Interest Rates,” IMFdirect, 10 April 2016.
³ Leading critics include Claudio Borio, Leonardo Gambacorta and Boris Hofmann, “The Influence of Monetary Policy on Bank Profitability,” BIS Working Paper No. 514 (2015), Basel: Bank for International Settlements.
⁴ Atsuko Fukase, “Negative Rates Hit Mizuho Earnings,” The Wall Street Journal, 31 July 2016; and Zacks Equity Research, “Mitsubishi UFJ’s (MTU) Q1 Earnings Fall on Low Gross profits,” Nasdaq, 2 August 2016.
⁵ Lower interest rates may reduce productivity growth, by encouraging consumption booms and reducing incentives to improve resource allocation. See Gilbert Cette, John Fernald, and Benoît Mojon, “The Pre-Great Recession Slowdown in Productivity,” Document de Travail N.586 (2016), Paris: Banque De France.
⁶ Carlos Arteta, et.al., “Negative Interest Rate Policies: Sources and Implications,” Policy Research Working Paper No. 7791 (2016), Washington, D.C.: World Bank Group.

Implications of Negative Interest Rates for Asia is republished with permission from Asia Pathways

The post Can Negative Interest Rates be Beneficial? appeared first on Economy Watch.

Tomorrow’s Bank of Japan and Federal Reserve meetings are serving to dampen activity in the foreign exchange market.  The US dollar is little changed against the euro, yen, and sterling.  The Antipodeans are firm.

Tomorrow’s Bank of Japan and Federal Reserve meetings are serving to dampen activity in the foreign exchange market.  The US dollar is little changed against the euro, yen, and sterling.  The Antipodeans are firm.

Minutes from the recent RBA meeting provide no fresh insight. The central bank has an easing bias, which it is in no hurry to act upon or jettison.  The Australian dollar is in the upper end of yesterday’s range, but unable to extend above its (~$0.7575) high.   Initial support is pegged near $0.7530. 

The Kiwi is bid as milk prices have rallied ahead of today’s auction. Intraday technicals warn of risk that the fact may be sold now that the rumor has been bought.  Buying stalled near $0.7360. Support is seen in the $0.7300-$0.7310 area. 

The dollar slipped a few ticks below yesterday’s low against the yen.  However, there is no momentum, and the range is narrow.  There is great uncertainty of what the BOJ will do tomorrow.  While much talk has been about its activity in the JGB market, new speculation is that may shift its focus in its ETF purchases away from the Nikkei 225 toward the Topix and Nikkei 400.  Apparently, on such speculation, the Nikkei 225 edged lower while the Topix and Nikkei 400 posted modest gains after the markets re-opened from yesterday’s holiday.  Ahead of the BOJ, the JPY101.50-JPY102.00 range is likely containing the greenback.

The euro was confined to a little more than a 10-tick range in most of the Asian session but then staged a quick rally (1/3 of a cent) to almost $1.1215, which is a 50% retracement of the leg down since September 15.  Initial support is pegged at $1.1170.  The news stream has been light. Following the CDU’s loss of support in two state elections this month, there is heightened speculation that Merkel may not run for a fourth term as Chancellor next year.  However, in her post-mortem yesterday, we detect a subtle shift in Merkel, a master tactician. 

She seemed to recognize the need to modify her immigration stance.  The CSU from Bavaria, which has always supported the CDU candidate, has drawn a line.  It wants Merkel to agree to a 200k immigration cap in order to support her fourth term.  There are no more state elections this year.  The CDU annual convention will be held in December.  It is not clear whether Merkel will use that forum to announce her intentions.  It would seem to be in her interest to not declare until absolutely necessary, which deters others from announcing.  

Sterling continues to trade heavily near $1.30.  Contrary to some speculation earlier (denial) that Article 50 would not invoked, word from the EU Summit is that Prime Minister May is signaling that divorce proceedings will likely begin in the first part of next year.  News today is that the head of Germany’s IFO wants a soft deal with the UK, so as not to cut the EU’s nose to spite its face.  The head of the IFO claims that the UK’s diminished influence in the EU is sufficient price.

Many European officials seem to disagree.  Recall that reports from the summit suggested that some officials thought that if their demands were sufficiently strong, the UK would balk at Brexit.  This too seems fanciful.  While the integration has been deep and complex, the key divisive issue is the UK’s desire for access to the single market without having to accept EU migration, though it is not a member of the Schengen zone. 

We have been skeptical of the UK narrative that the EU changed from what the Conservatives that led the joining had anticipated.  The UK consistently campaigned for a broader union rather than a deeper union.  Now, nearly every country that wants to join has (except Turkey, and maybe Ukraine).  The broader union, which speaks to the UK’s successful strategy, meant that the governance had to change away from unanimity.  This means that the UK strategy ultimately led to its loss of it veto.  Nothing fails like success, even though the instability in Northern Africa and the Middle East, spurred the refugee crisis, for which there is no easy solution and was mishandled. 

Even if the promise of a referendum allowed the Conservatives to defy expectations and secure an outright parliament majority, three things that Cameron could have done could have changed the outcome.  First, he could have campaigned harder and presented a strong, compelling case of why UK historically has gotten involved with Continental politics to shape the outcome. 

Second, he could have taken a page from Scotland, and said because the referendum is about the future, 16-years should be allowed to vote.  They may not have voted in high numbers, but a strong turnout was not necessary to change the close results.  Third, recognizing the importance of the treaty with the EU, Cameron could have insisted that it is not the UK way to make such an important decision by the “petit oui” as the French did when it agreed to EMU.  Cameron could have insisted on a 60% or 2/3 majority to accept the conclusion of the non-binding referendum. 

The US reports August housing starts and permits today.  Recall July housing starts represented a new post-crisis high.  A small pullback is expected in August.  On the other hand, permits, which are including among the leading economic indicators, slipped in July and are expected to bounce back in August.  Barring a dramatic surprise, the time series is not typically a market-mover.  This is especially true today ahead of the conclusion of the FOMC meeting tomorrow. 

The September Fed funds contract continues to imply an average effective Fed funds rate of 40.75 bp this month.  It has averaged 40 bp until now.  However, on the last trading day of the month, the Fed funds effective rate has consistently fallen to 30 bp.  If this pattern continues, then Fed funds will average 39.66 bp this month.  Our calculation puts us closer to the CME assessment of 12% chance of a hike rather than the Bloomberg estimate of 20%.  That said, we are intrigued by the press reports suggesting that for the first time in this cycle, there is a disagreement among primary dealers, with two holding out the likelihood of a hike.

Dollar Goes Nowhere Quickly is republished with permission from Marc to Market

The post The BOJ Unknown and the FOMC Sort of Known appeared first on Economy Watch.

The market has not changed its mind.  Following Brainard’s comments yesterday the market had downgraded the chances, which were already modest, of a Fed hike next week.  The September Fed funds futures is unchanged on the day.  The implied yield of 41 bp matches the 50-day moving average. 

The market has not changed its mind.  Following Brainard’s comments yesterday the market had downgraded the chances, which were already modest, of a Fed hike next week.  The September Fed funds futures is unchanged on the day.  The implied yield of 41 bp matches the 50-day moving average. 

Maybe the suggestion that 25 bp hike in the target range somehow would make the Federal Reserve imprudent, incautious or impatient is a bit much.  Without expectations changing the US 2-year yield is near 80 bp. It is eight basis points above its 50-day moving average.  The 10-year yield is poking through 1.70%, which is about 18 bp above the 50-day moving average.    

It is premature to make a hard conclusion.  However, investors should be open to the possibility the sell-off in asset prices in the US, and especially the backing up of US interest rates and the steepening of the yields curve may be a protest against such easy monetary policy in the US.

That hypothesis seems to be a corollary to the idea that monetary policy in Japan and Europe is maxed out, if not in terms of the lowest rates can go into the phantom-zone below zero and amount of assets that can be bought, then as a function of the political will of policymakers. 

The sharp backing up in yields is not just a function of the US.  European benchmark 10-year yields are mostly up 3-5 bp today and 20-25 bp over the past week.  The German 10-year yield is at seven bp, the highest since Brexit; two months ago, it was near minus 30 bp.  The rising bond yields in Europe not only reduce the amount of negative yielding securities but also increases the universe of assets the ECB can buy. 

The 10-year JGB has trailed a bit.  It too was near minus 30 bp in July, but it has only managed to near zero.  The 20-year JGB had almost no yield two months ago, and it is near 50 bp now. 

The US Dollar Index has been steadily moving higher.  We continue to monitor an uptrend line drawn off the April, June and August lows, which caught the September low as well.  It comes in near 95.55.  Yesterday and today have been about consolidation.  The US Dollar Index is trading today within yesterday’s range, which was within last Friday’s range.  A move above 95.60 is needed to signal another run at 96.00-96.25. 

There is shorter uptrend in the euro that connects the July, August, and September lows.  It is near $1.1170 today.  Today is the also the euro’s second consecutive inside day; coiling, as it were like a spring. Just above 7%, one-month implied volatility is near the lowest level of the year. 

Sterling is having a rough day.  The lack of additional uptick in consumer prices in the UK, which leaves the headline rate still at its highest level in a couple of year, has spurred the largest drop in sterling in five weeks.  Sterling’s drop has pushed it through a one-month up trendline (since August 15 low) that came in near $1.3210.

 A week ago, sterling was bid above $1.34 to approach the top of its trading range post-referendum.  The subsequent price action reinforces the importance of upper end of the range.  Sterling drew bids last time (late-August) near $1.3065. 

The dollar is firm against the yen, despite the sell-off in stocks, which is often seen a yen-supportive.  Perhaps, the rise in US interest rates, which is understood as yen negative, is a more important consideration at the present.  In addition, the outcome of the BOJ meeting is more uncertain for investors than the FOMC meeting.  Within a JPY101.20-JPY103.20 range, it is difficult (for us) to have a strong view of the near-term price action. 

Rising yields, falling commodity prices, and perhaps the risk-off mood are punishing the dollar-bloc currencies.  We have been looking for a push toward CAD1.3200, and it is being approached today. Immediately beyond there is the high from July near CAD1.3250 and the 200-day moving average now around CAD1.3270.  

Since September 6, the US dollar has risen against all the major currencies and the most against the Canadian and Australian dollars.  They have lost 2.4% and 2.9% against the greenback respectively. The Aussie was trading near $0.7730 as recently as five days ago.  Today it has approached $0.7440.

The fact that it is beyond the lower Bollinger Band (~$0.7475) warns the shorts ought to be cautious. In addition, the $0.7450 area met the 50% retracement objective of the rally since late-May.  The 61.8% retracement is found just below $.7380 and other technical support near $0.7400.

Thoughts on the Price Action is republished with permission from Marc to Market

The post Maxed Out Monetary Policy appeared first on Economy Watch.

Our approach to Fed-watching is clear:  Among the cacophony of voices, the Troika of Fed leadership, Yellen, Fischer and Dudley provide the clearest signal. They are most often on message, and their comments have been the best indications of policy.  

Remember at the end of last summer; Dudley said a rate hike was less compelling.  This foretold the lack of hike last September.  Earlier this year, as several regional presidents were talking up a rate hike, Yellen pushed against it. 

Our approach to Fed-watching is clear:  Among the cacophony of voices, the Troika of Fed leadership, Yellen, Fischer and Dudley provide the clearest signal. They are most often on message, and their comments have been the best indications of policy.  

Remember at the end of last summer; Dudley said a rate hike was less compelling.  This foretold the lack of hike last September.  Earlier this year, as several regional presidents were talking up a rate hike, Yellen pushed against it. 

Governor Brainard is the newest member of the Board of Governors.  Well, technically, Fischer was confirmed at the same time, but his experience is vastly superior.  Brainard has completed a little more than two years of her 12-year term.  This is not to impeach her comments.  They are thoughtful and well considered.  They were thoughtful and considered six months ago too.  She has not changed her assessment, though circumstances have changed. 

First, the global risks appear to have eased.  The UK referendum has come and gone.  The global capital markets have become decoupled to a large extent from what happens to the Chinese yuan and stocks.    It is the politics of several emerging market countries, like Brazil, Mexico, Turkey, and South Africa, not the economics that has been the source of consternation by investors. 

Second, the nine-month soft-patch in which the US economy grew less than 2% appears to be ending now.  We are familiar with three regional Federal Reserve’s GDP trackers.  The St. Louis Fed’s and the Atlanta Fed’s models point to an annualized pace more than 3% here in Q3.  The NY Fed says the economy is tracking 2.8%. 

Third, fact that the Fed does not have conventional monetary tools at its disposal is an argument that has been developed to encourage policymakers to gradually raise interest rates. However, Brainard turns this argument on its head.  She suggests that the limited arsenal should make the Fed even more cautious about taking risks, such as raising rates.

Brainard argued that guarding against downside risks is preferable to preemptively raising rates to guard against upside risks.  This seems to misunderstand the purpose of raising rates.  It is not to ward off too tight of a labor market, too strong of growth, or too high of inflation. A series of several rate hikes over the next couple of years would give it the interest rate tool again. 

We can agree with Brainard that there is no hurry ad the Fed should be cautious, as macroeconomic relations may have changed, such as employment and inflation.  However, given the forward momentum of the economy, the improvement in the labor market, the modest upward pressure on prices, the Fed has arguably been cautious and patient.  Would a second rate hike in two years change that assessment?

We wonder too if the significance of 25 bp increase in the Fed funds target range is not being exaggerated.  The real funds rate remains below zero, which is a measure the monetary stance, even on a 25 bp increase.  It is hard to see the impact of the December 2015 rate increase.  Three-month LIBOR has risen nearly as much due to the reforms in the US money market as it did in response to the Fed’s hike.   At the end of the day, we agree with Brainard.  Monetary policy should be cautious and prudent.  A 25 bp hike does not make the Fed incautious or imprudent. 

Nevertheless, Brainard is the second Fed Governor (Tarullo being the other) that seemed demur from the Troika (Yellen, Fischer, and Dudley).  The market downgraded the chances of a Fed hike in September.  Bloomberg’s calculation (WIRP) has fallen from 30% before the weekend to 22%.  The CME (where the contract is traded) sees the probability falling to 15% from 24%.  For the record, the probability shift was a function of the implied yield falling three-quarters of a basis point to 41 bp. 

The US two-year note yield fell a little more than a single basis point on Monday.  The decline in response to Brainard was less than four bp from the 80 bp level that was seen as the pre-weekend move was continued.  The Financial Times called this a “plunge,” but this is hyperbolic.  Recall that as recently as the middle of last week; the yield was near 71 bp. 

While the dollar and US interest rates were little changed at the end of the session, the S&P 500 sustained a strong bounce.  The S&P 500 open below the pre-weekend lows.  This created a gap that was soon filled.  The gap created by last Friday’s sharply lower opening is key.  It is found between 2169.06 and 2177.49.  To repair the technical damage, the S&P 500 would ideally close above the top of that range.  Most bullish would be gap higher on Tuesday, which simply does not look to be in the cards. 

Asian stocks performed poorly in light of the US equity rally and Chinese economic data. The MSCI Asia-Pacific is flat, while MSCI EM is up 0.25% early in the European morning.  China reported a series of data that lend credence ideas that the world’s second-largest economy is stabilizing.  In turn, that keeps speculation of easier monetary policy in check. 

Industrial output rose 6.3%, a little better than expected and a bit faster than the 6.0% pace in July.  Retail sales rose 10.6% after a 10.2% in July.  Fixed investment rose 8.1% in the first eight months.  This is steady from the rate reported in July, but it is a little above expectations.    

Some economists use power output to generate insight into growth, with the GDP figures seen as suspect.  Power output rose 7.8% in August from a year ago.  Just like capital investment in China has reached a point of diminishing returns, so too has energy output. There may be a gap between energy output and consumption.  It may also be that low energy costs have deterred efficiencies.  In addition, the increase power output may reflect more industrial activity. 

One detail that caught our attention was China’s steel output.  Recall that excess capacity in that industry is sufficiently salient to make it into the G20 statement.  Chinese officials have indicated intentions on shuttering some capacity.  They have around half of the world’s steel capacity.  However, today’s data showed steel output was 3% higher in the year through August. 

The dollar was firm before Brainard’s-induced gyrations, and it regained its footing. It was technically notable that the euro remained confined to the previous session’s range. It requires a move above the $1.1270-$1.1300 band to lift the tone.  On the downside, initial support is pegged at $1.1200.  The dollar was pushed a bit lower in Asia against the yen, falling to nearly JPY101.40.  It stopped shy of the objective we saw near JPY101.20.  The JPY102.15 area marks the first hurdle.  Sterling remains in narrow ranges around $1.3300. The dollar-bloc is under some pressure.  The Australian dollar rally yesterday has been pared and it is back probing support in the $0.7500 area.  A break of $0.7480 may shake out some of the late-longs.  We continue to look for the greenback to test CAD1.3150 on its way to CAD1.32.

Much Noise, Weak Signal is republished with permission from Marc to Market

The post Is there Room to Raise Rates? appeared first on Economy Watch.

The shaving of 2017 and 2018 growth forecasts, recognition of continued downside risks did not prompt the ECB to adjust monetary policy.  Rates were left unchanged, as widely expected.  The ECB also refrained from extending the asset purchases.  This is somewhat disappointing.  It was the only action that investors were discussing as a possibility.  Bond yields appear to be backing up in response. 

The shaving of 2017 and 2018 growth forecasts, recognition of continued downside risks did not prompt the ECB to adjust monetary policy.  Rates were left unchanged, as widely expected.  The ECB also refrained from extending the asset purchases.  This is somewhat disappointing.  It was the only action that investors were discussing as a possibility.  Bond yields appear to be backing up in response. 

Many will suggest that the downgrade of the growth outlook is the most important takeaway from the ECB’s press conference.  We wonder whether, in the medium and longer terms, the announcement that appropriate Eurosystem committees have been instructed to evaluate the stimulus options is more important than the small tweaks in economic forecasts.  This seems to be in preparation of additional steps that may be necessary if the asset purchases are indeed extended.

If the asset purchases are extended, there may be a need to change from the current decision-making principle that is based on the capital key.  While the capital key will be included in the review, it may be resilient because of the precedent that abandoning it would entail.  There are other steps that can be taken to free-up more assets that can be bought in the program. 

Draghi pointed out several times that the forecasts for inflation to rebound to 1.2% next year and 1.6% in 2018 are predicated on continued accommodative monetary policy.  Although he said that there was no discussion of extending the asset buying past March 2017, he explicitly cited it as a possibility. 

Draghi appeared to be taking a page from the footballers by going on the offense as reporters’ questions put him on the defense.  He vigorously defended the combination of orthodox and unorthodox policies, claiming they are effective.

The transmission mechanism which had previously been a challenge is now working well, he judged, and fragmentation has been reduced. This is why no new policies, including extending the asset purchases, were announced:  They are not needed now.  Economic and monetary developments are moving in the desired direction. 

Draghi was not very sympathetic to claims that ECB policies were squeezing banks.  He noted the important support that the ECB has provided for the sector.  He briefly hinted at the need for many European banks to change their business models.  He suggested that not all bank problems could be laid at the ECB’s door. 

To those who say that ECB monetary policy is exhausted, Draghi reiterated that the ECB has the will, capacity, and ability to do more within its mandate.  At the same time, he clearly recognized that monetary policy cannot do everything.  He pointed to the G20 statement that recognized that countries should not rely exclusively on monetary policy. 

Countries in EMU who have fiscal space should use it.  Germany has fiscal space. Over the past week, Germany has reported soft PMI figures and, yesterday, an unexpectedly poor industrial output. Ironically, it may take an economic downturn in Germany to get the government to loosen its purse strings. 

When everything is said and done, more was said than done.  The Eurosystem committees will provide an evaluation of measures, while the ECB’s staff shaved next year’s growth and inflation projections. There is no date provided for the committees’ report, but it seems clear it must be delivered before the current buying program is to end (March 2017).  Indeed, a decision must be made somewhat before then.

That is still six months away.  Although we recognized that the ECB could have announced an extension of its program today, we also appreciate that officials typically do not make a decision until they must. 

After hovering around $1.1250 since Monday afternoon, the euro was bid to almost $1.1330. The high the euro reached just before the Jackson Hole optimism was $1.1340.  Momentum appears to be stalling as the European session winds down.  On the downside, $1.1275 was the low the euro reached since the decision was announced.  With the two-year interest rate differential sitting near three-week lows, and a soft US retail sales report expected in the middle of next week, a break of $1.1250 could be significant.

Separately, note that the Dollar Index, for which the euro is the largest component, has tested an uptrend line drawn off the May, June and August lows.  It came in today near 94.45.  The Dollar Index came within a tick of it and appears stabilizing with the help of some short-covering by intraday participants.

Draghi Says Little, Door Still Open for More is republished with permission from Marc to Market

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The last two weeks have been about the US.  First, it was Jackson Hole. The leadership of the Federal Reserve, Yellen, Dudley and Fischer sang from the same songbook. They all signaled that the time was approaching to take another step in the normalization of monetary policy, without specifying precisely when.

Then it was the US employment report, which Fischer had specifically identified as important.

The last two weeks have been about the US.  First, it was Jackson Hole. The leadership of the Federal Reserve, Yellen, Dudley and Fischer sang from the same songbook. They all signaled that the time was approaching to take another step in the normalization of monetary policy, without specifying precisely when.

Then it was the US employment report, which Fischer had specifically identified as important.

After the July employment data in early August, the US 2-year yield was at 72.2 bp.  It finished last week at 78.6 bp.  It was down six basis points on the week, with the decline mostly the result of the disappointing manufacturing ISM earlier in the week.  The yield closed fractionally higher after the August employment report before the week the weekend. 

The September Fed funds futures implied a yield of 41 bp after the July jobs data, and after everything was said and done, it implied a 41.5 bp at the end of last week.  The net change after the August jobs report was a quarter of a basis point or the spread between the bid and offer.   By our calculation, the implied 41.5 bp yield is the same as a 22% chance of a rate hike later this month. Bloomberg’s WIRP, which has become a widely cited benchmark, puts the odds at 32%.   

The CME, where the Fed funds futures trade, offers its calculation here.  Its estimate is close to ours, and it puts the odds of a rate hike at 21%.  Reasonable people may have different ideas on where Fed funds will average after the hike.  They have been averaging 40 bp since late-June, but before then, they often were below the midpoint of the 25-50 bp range.  We made the unbiased assumption that Fed funds would average the midpoint of the new 50-75 bp range or 62.5 bp.  

The US economy is poised to snap a three-quarter period of sub-2% growth.  The NY Fed’s GDP tracker was flat at 2.8%.  The Atlanta Fed’s tracker is at 3.5%, little changed from its first estimate for Q3 on August 3 of 3.6%.  It was taken down to 3.2% after the construction spending and manufacturing ISM, but marked higher after the trade figures before the weekend that pointed to a smaller drag from net exports. 

The most important takeaway is that the composition of growth is changing this quarter.  Consumption will pullback after its second strongest quarter since the crisis.  It looks as if government and investment will improve over the second quarter.  The wild card is inventories. It is difficult to have much confidence with the limited data that is currently available, but it looks like the inventory headwind may still be there, even if diminished. 

Four central banks from high-income countries meet next week:  The Reserve Bank of Australia, the Bank of Canada, Sweden’s Riksbank and the European Central Bank.  The first three will likely come and go with little fanfare. 

It is well known that the RBA would prefer a weaker currency, but it not prepared to do much about it.  Even at a record low, the cash rate remains well above other countries’ equivalent.  It is Stevens last meeting before his deputy Lowe succeeds him.   The Bank of Canada cannot be happy with the 1.6% annualized contraction in Q2, but it will look past the short-run disruptions.  June growth exceeds expectations. 

With a minus 50 bp repo rate and a minus 1.25% deposit rate, and a bond-buying program, Sweden’s Riksbank, the oldest central bank in the world, should be counted as among the most aggressive of central banks presently.  Its economy grew 3.1% year-over-year in Q2. Deflation has ended, and the CPI is rising gradually.  It enjoys a large current account surplus.  There is no pressure for fresh action. 

That leaves the ECB.  The meeting is significant.  Staff forecasts will be updated.  Two things are patently clear.  The economy does not have much forward momentum.  Price pressures remain disappointingly subdued.  In addition, it is safe to assume that despite Draghi’s please, the reform drive has stalled, or worse.  Nor is there much prospect for fiscal stimulus.  Yes, the tragic earthquake in Italy could see a bit more spending, and while it may be significant for the rebuilding efforts, it is unlikely to be on a sufficient scale.  It is small enough for to meet Brussels’ muster, it probably will not do much on the national level, let alone the region. 

It comes down to Germany, and it is a question of politics; of will, not means.  Given the decline of Merkel’s popularity, one might tempted to give credence to speculation that she is considering offering a tax cut.  In some other countries, maybe, but seems unlikely in a country where there is one word for both guilt and debt.  Moreover, maybe it misreads German politics.  Merkel faces two challenges, and both are to her right. 

The most important is with the Bavarian CSU.  The strain between the two began over Merkel’s acceptance of making efforts to keep Greece in EMU.  There were some domestic policy differences, like minimum wage, but Merkel’s immigration policy was the poisoned chalice.  The CSU may run their own candidate as Chancellor if the egos are strong enough and if there was a reasonable chance of success.  The mandatory caveat is that Merkel’s rivals have often underestimated her to their chagrin. 

Her other challenge is with the AfD.  Although the party has been wracked by internal discord and fissures, the AfD, has struck a responsive chord with its anti-immigration rhetoric.  Through a leadership change, it has morphed from an anti-EMU party to anti-immigrant. It is likely to be an important force in next year’s national elections.  It is possible that the AfD edges past the CDU in the weekend’s Mecklenburg-Vorpommern state election, but in national polls, its support is around 12%. 

Merkel tacks to the right with a greater emphasis on law-and-order issues, but this does not seem sufficient to solidify her right flank.  These domestic challenges suggest that Merkel will have to take a hardline on European issues over the next year.  

So, we return to the ECB.  Over the last few months, the TLTRO II and corporate bond purchase programs have been implemented, but it is too early to evaluate the results. There does not seem to be a consensus to do more, and, perhaps, the most that can be reasonably expected is to extend the asset purchase program beyond of March 2017.  That is probably the path of least resistance, and if not now, when?  Given the ECB’s modus operandi, the next window of opportunity would be with updated staff forecasts in December. 

If the ECB does not announce an extension of its QE, many market participants are likely to be disappointed.  They could express the disappointment by selling bonds, and possibly other risk assets.  However, Draghi could mitigate the backing up of rates by implying that procedurally, the formal decision would be made later, but there was a consensus of dissatisfaction. 

However, the decision to extend the purchases is more complicated that it may appear.  An extension of the program will require a secondary and tertiary decision about the pending shorting, primarily in Germany but experienced on the margins by several other sovereigns as well.  There are several self-imposed rules that could be altered.  The one that has captured the most imaginations is the abandonment of the capital key.  The capital key, in effect, means that ECB buys more bonds are larger countries than smaller countries.

There could be other decision-making rules.  The fanciful one is that rather than buy bonds proportionate to GDP, the ECB could buy bonds proportionate to the size the debt market.  This would favor, for example, Italy over Germany.  It would solve the shortage challenge but spur other issues.  The capital key is an important decision-making principle and many countries,

There are other ways to address the shortage issue.  The most straightforward is to remove the interest rate floor on purchased securities.  Currently, the floor is the deposit rate, minus 40 bp.  There is not a necessary link between the yield the ECB receives for overnight deposits and what the yield it pays when it buys a negative yielding bond.  In these operations, it is not borrowing short and lending long, which would make in fact link the two rates. 

There is appears to be little appetite to lower the deposit rate further, perhaps in general, but it particularly now.  In addition, it could not be counted on as a reliable way to address the scarcity issue, as yields can be driven lower still.  It could become a little like the dog chasing its tail. The yields fall below the ECB’s floor.  The floor is lower.  Yields fall further.  So far, in this experiment, that is what has happened.  Lather, rinse and repeat. 

Some have suggested raising the cap or issuer limit from the current 33%.  While this is a bit arbitrary (what is the difference between say 33% and 45%?), there is an underlying money and risk management issue.  The point is that neither lifting the issuer limit or cutting the deposit rate deeper into negative territory have limited potential to be scaled. 

The Bank of England does not meet next week, but the MPC will meet the following week on September 15.  The recent string of data suggests that the Brexit decision was a shock to the economy.  The July data, like the industrial output, manufacturing production and construction that will be reported next week will reflect that shock.

However, the news has been superseded.  The August manufacturing and construction PMIs that were reported last week were better than expected.  The combination of no immediate policy changes, including triggering Article 50 and the divorce proceedings, and the decline in sterling and the fall in interest rates may be underpinning British resiliency.  Because of the structure of the UK economy and especially the high proportion of household debt (mortgages) are at variable rates, the fall in rates can be passed through relatively quickly.  It has a one-off impact, as does the decline in sterling. 

The August service PMI will be reported on Monday (while the US markets will be closed for Labor Day).  The depreciation of sterling will have less impact on the service sector. Although the service sector is the largest part of the UK economy, we suspect that it has to be a significant disappointment to boost expectations for a rate cut at the MPC meeting in the middle of the month. 

If May is not going to trigger Article 50 until next early next year, at the soonest, and the BOE is on the sideline, then there is no reason why the Brexit decision needs to be the dominant driver of sterling over the next, say, couple of months.

That said, May indicated that the government will outline is broad plans for the post-exit relationship with the EU.  Brexit Minister Davis will present this to parliament.  It may ease speculation in some quarters that due to the complexity of the issue, or the second thoughts by some, the Brexit was not really going to happen. 

If the yen’s strength is the most counter-intuitive development this year, then the market’s insensitivity to Chinese developments may be among the most welcome development.  The moves that were so disruptive in August 2015 and January this year have continued, but global markets have become decoupled.  Recent data have suggested the economy is stabilizing, and the capital outflows have slowed. 

There are two reports in the coming days that could have impact outside of China.  The first is the inflation measures. Deflation in producer prices is slowing, and the CPI appears stable.  The year-over-year rate has averaged 1.9% in the May through July period, the same as over the past 12 months.  The fall in grain prices warns of the risk of easier price pressures. While easing of price pressures may give the PBOC scope to ease monetary policy, officials seem in no hurry to do so. 

The other report that may impact investors is China’s trade balance.  China is the largest trading partner for many countries in Asia.  Its demand for many commodities is understood to impact prices.  China’s trade surplus appears to have begun growing again.  It has averaged $45.9 bln through July, according to Chinese figures, which is nearly three billion more than the average during the first seven months last year.  The August surplus is expected to be near $58.3.  It would be the second consecutive month above $50 bln, for the first time since December 2015 and January 2016. 

The US trade figures for July were largely overshadowed by the employment data except for economists trying to estimate Q3 GDP.  However, there was one nugget that is suggestive of coming trade tensions between the US and China.  In July, the US recorded an overall deficit of $39.5 bln. The US-China deficit was $30.3 bln.  We suspect that regardless of the outcome of the US election, among the most important economic issues is how China’s surplus capacity will be absorbed.  To the extent that China tries to export it, the more intense the clash.  The excess capacity in the steel industry was highlighted in the draft of the G20 statement.

Parsing Divergence: Focus Shifts from Fed to ECB is republished with permission from Marc to Market

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The world changed after the financial crisis in 2008. What lessons can we draw on the role of central banks since then?

There are at least four lessons we have learned.

The world changed after the financial crisis in 2008. What lessons can we draw on the role of central banks since then?

There are at least four lessons we have learned.

The first is that the central banks in rich countries can use a broader range of policy tools than was conventionally understood. Central banks in these countries have added quantitative easing into their arsenal. It involves central banks buying government and corporate bonds, which requires them to transfer money to banks and other bondholders. The aim is to encourage banks to lend which in turn stimulates economic growth.

Central bank governors have also started using what is known as forward guidance. This means that they are becoming more transparent, using public statements to inform the public about their views on interest rates and how these might change over time.

While these policies helped limit the severity of the crisis, their effectiveness over time is open to question. In the rich countries, growth has been sluggish. Inflation remains below target and the policies have exacerbated inequality by enriching bondholders and owners of shares who tend to be rich people and institutions without commensurably helping poorer people who depend on a growing economy to create jobs and decent wages. In addition, the policies have generated volatile flows of “hot money” – money that’s not committed for long-term investment but for short-term quick gains – from the rich countries into developing countries. This has complicated economic and monetary policy making in developing countries.

The second lesson is that central banks, like the South African Reserve Bank, that have bank supervisory responsibilities have had to rethink their remit. Previously, the South African Reserve Bank could focus on the safety and soundness of each bank individually. The crisis taught that there are so many transactions being undertaken between banks and between them and other financial institutions that they cannot adequately assess the safety and soundness of an individual bank without considering interactions between it and other financial institutions.

Thirdly, central banks now understand that the banking system cannot be treated in isolation from the rest of the financial system. The broader system includes insurance companies, pension funds, hedge funds, money market funds, private equity funds and micro-finance institutions.

If the central bank is to be responsible for financial stability, it needs to have the authority to oversee the activities of all the institutions that can affect financial stability. This requires new policy tools and, in the case of South Africa, clarifying the central bank’s mandate in relation to financial stability. Currently the SARB has clear supervisory authority over banks but not over other financial institutions.

Fourth, central banks have come to realise that their decisions can have an impact on inequality. For example, the capital requirements they set for banks – how much capital they need to hold against particular types of assets – influences how banks allocate credit and this tends to work against small businesses and poor people. This has exacerbated inequality within societies.

How has the South African Reserve Bank adapted to the changing environment

The Reserve Bank is an independent institution that is required by law to maintain price stability in the interest of balanced and sustainable economic growth. It is therefore obliged to meet the inflation target set by government. However, it retains the discretion to choose what policy instruments it will use to reach the target. This part of the Bank’s responsibilities has not been affected by the financial crisis.

The same is not true of its banking supervisory responsibilities. Since the crisis efforts to establish international standards that all banking and financial sector regulators adopt have intensified and have resulted in new international institutions like the Financial Stability Board. In addition, banking supervisory authorities around the world are having to consider how they coordinate responsibilities for banking supervision and for overall financial stability.

How the safety and soundness of the financial system will be supervised in South Africa has not yet been finalised. It will be clarified when the new Financial Sector Regulation Bill becomes law.

These changes will raise organisational challenges. How will the bank balance its different roles? How will it execute its responsibilities, particularly when it comes to financial stability, without undermining its independence? These new responsibilities can adversely affect central bank independence because they can influence the level of equality in society and who has access to credit. This can lead to the public demanding more accountability for central banks.

The bank keeps inflation in check largely by raising interest rates. This in turn affects growth. Some argue this can be counter-productive if an economy isn’t growing. How should the bank respond?

The bank determines for itself how it achieves the inflation target but it does not set the target. South Africa’s is 3%- 6%. It also can decide how long it’s willing to tolerate inflation being outside the range.

In deciding how to exercise this discretion, the central bank needs to take into account a number of players’ concerns. These include the government, the views and actions of investors – domestic and foreign – as well as financial institutions.

On top of this, it has to weigh up whether the causes of depressed growth are likely to respond to raising interest rates, or if they require other responses. These could include revisions in the allocation of budgets, which is the responsibility of National Treasury. It could also include changes in the structure of product and labour markets, which are the responsibilities of other government ministries or agencies.

Raising interest rates is unlikely to be effective if the real causes of low growth are the structure of the economy and labour markets or other issues such as electricity supply.

On the other hand, if the causes include volatile financial flows and confidence in the country then the bank’s decision would have an impact.

Central banks can do much more than print money. Some dabble in development finance and financial inclusion activity. Is this a good idea?

Currently, the South African Reserve Bank does more than monetary policy. It supervises banks. It has responsibilities regarding financial stability and the operation of the payment system.

Should it be given additional responsibilities? The answer depends on two considerations. First, is it the best-placed institution to take them on? Second, will it dilute focus on its primary mission?

Increasing the number of its responsibilities could also have implications for the clarity of its mission and its independence. Calls for greater public accountability will grow if the bank takes on responsibilities that have an impact on inequality and on access to credit, for example. This is because in a democracy the expectation is that decisions which affect the allocation of resources and opportunities will be made by elected leaders who can be held publicly accountable and not by appointed technical experts like central bankers.

The bank should therefore only take on new functions when it is clear that it is the best placed institution to do so.

The role of central banks is changing. What South Africans should look out for is republished with permission from The Conversation

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