Monetary policy divergence

Monetary policy divergence –
a new transitory regime for
global central banks
Investment
Forum
Martin Hochstein
Senior Strategist,
Global Economics &
Strategy, AllianzGI
Over the course of the Great Financial Crisis, global central banks
became the main policy actors to address both unprecedented stability
risks to the financial system and the deepest global recession since the
Great Depression of the 1930s. In response, monetary authorities have
cut their policy rates more than 600 times during the past seven and a
half years and also introduced a wide range of unconventional policy
measures to overcome the assumed zero lower bound of interest rates.
Divergent monetary policy landscape
Following this long lasting period of broad based
stimulus, the initial rate hike by the Federal
Reserve at the end of last year finally kicked off a
new episode of monetary policy divergence, an
important investment theme that may contribute to
higher economic and financial market volatility over
the months ahead.
Global monetary policy is expected to become
more divergent in 2016. In order to classify the
anticipated divergent strategies and related
rationales, we pigeonholed the major central banks
in the industrialized and emerging world into
different categories. The tightening end of this new
policy spectrum is represented by a group called
“unconventional normalizers”, which basically
comprises the Federal Reserve and the Bank of
England. Why do we label them as “unconventional
normalizers”? Normalizers, because the gradual
rate hikes expected by both central banks over the
course of this year constitute a slow withdrawal
of monetary stimulus and a first step towards a
medium-term normalization of their policies, but
not restrictive policy actions per se. Unconventional,
because both central banks already announced that
they won’t follow the common course of action and
scale back their bloated balance sheets first before
raising interest rates, but to maintain huge amounts
of excess reserves in the banking system well into
the hiking cycle instead. While the current “low
growth, low inflation, strong dollar” environment
puts a question mark on the Federal Reserve’s
ability to deliver the full 100 basis points of rate
hikes, recently indicated by the median projections
of FOMC participants for 2016, we nevertheless
expect a steeper hiking path than currently priced
into the money market curve. The Bank of England,
on the other hand, will probably start raising its
base rate at some point later this year, in light of a
further tightening of the labor market and gradually
Monetary policy divergence – a new transitory regime for global central banks
Chart 1: Central bank landscape – 2015 vs. 2016
unconventional
conventional
USA
2015
Mexico
South Africa
United
Kingdom
tightening
tightening
2016
Brazil
Canada
USA
United Kingdom
Switzerland
Russia
China
easing
Australia
India
Russia
South Africa
Mexico
Canada
Australia
India
Japan
Euroland
China
conventional
Switzerland
Japan
Euroland
easing
policy stance
Brazil
unconventional
policy tools
Source: Allianz Global Investors Global Economics & Strategy, December 2015
higher inflation rates. But Governor Mark Carney
emphasized again more recently that the central
bank wants to see the preconditions of above-trend
growth, increasing domestic cost pressure and rising
core inflation to be met beforehand.
At the easing side of the spectrum are the ECB and
the Bank of Japan, whose strategies continue to
be dominated by lingering disinflation fears. Both
are expected to deliver more policy stimulus, even
beyond what’s already decided if necessary, in
order to address potential risks of a de-anchoring
of medium-term inflation expectations due
to a persistent undershooting of their inflation
objectives.
Several other central banks, the so called forced
followers, will be highly contingent upon the policy
actions of either of these two groups in 2016.
The Banco de Mexico, the South African Reserve
Bank and the Hong Kong Monetary Authority are
among those who have already raised policy rates
in response to the Federal Reserve and will have to
move in concert with the US central bank, either in
order to uphold their currency peg or to avoid even
more severe FX weakness and related disruptions
in capital flows. On the other hand, some of the
smaller European central banks, namely the Swiss
National Bank, the Danish National Bank and the
Swedish Riksbank might be forced to deliver even
more targeted easing to shield their currencies
against an unwanted appreciation as a side effect of
the expansionary ECB policy.
◀ easing
tightening ▶
Chart 2: Different rationales for divergent monetary policy actions
Group
Rationale
Central banks
Unconventional normalizers
Gradual rate hikes in response to closing output gaps but
no immediate shrinkage of central banks’ balance sheet.
US, UK
Forced followers
Central banks in lockstep with US Fed in order to avoid
severe FX weakness or disruptions in capital flows.
Mexico, South Africa,
Turkey, Hong Kong
Idiosyncratics
Policy mainly dominated by domestic factors.
Terms-of-trade victims
Ongoing accommodation to deal with the aftereffects of
commodity price weakness and related income shocks.
Canada, Australia, New
Zealand, Norway, Russia
Forced followers
Targeted easing to avoid unwanted FX appreciation
spilling over from expansive ECB policy.
Denmark, Switzerland,
Sweden
Disinflation fighters
More policy stimulus to address persistent undershooting
of inflation objectives.
Eurozone, Japan
Brazil
China, India
Source: Allianz Global Investors Global Economics & Strategy, December 2015
2
Monetary policy divergence – a new transitory regime for global central banks
Another group, the terms-of-trade victims, is also
expected to maintain a highly accommodative
policy stance or even deliver more stimulus in
the months ahead. These countries, in particular
Canada, Australia, New Zealand and Norway, are
still grappling with the aftereffects of tumbling
commodity prices and the related shock to their
national incomes. Finally, there are those idiosyncratic
central banks that will be primarily driven by domestic
considerations over the course of this year. The
People’s Bank of China, in particular, is expected to
continue following its current course and support the
ongoing restructuring of the Chinese economy with
additional monetary stimulus in order to mitigate
potential downside risks. The Banco Central do
Brasil, on the other hand, is confronted with a deep
recession but also rampant inflation and risks of a
further de-anchoring of inflation expectations. Hence,
the policy stance of the BCB remains skewed towards
more tightening and much needed monetary
tailwind might be still some way off in Brazil.
Chart 3: G-5 monetary base will continue to
expand in 2016
monetary base (% of world GDP)
24
20
16
12
8
4
0
2006
2008
US
2010
Eurozone
2012
Japan
2014
UK
2016
China
Source: Allianz Global Investors Global Economics & Strategy,
Bloomberg, December 2015
Emperors with no clothes: Are global
central banks running short of policy
options?
It’s obvious that global central banks have started
to navigate their policies in different directions.
Nevertheless, we have to stress that, on a
global scale, monetary policy will remain highly
accommodative for the foreseeable future. The
combined monetary base in G-5 countries (US,
Eurozone, Japan, UK and China), for example, is
expected to continue growing at a brisk pace
in 2016. But increasing policy divergence will
contribute to higher macroeconomic uncertainties
going forward and might therefore also lead to
rising volatility in financial markets.
One of the most widely discussed monetary policy
topics remains the question as to whether global
central banks are at risk of running short of policy
options. A glance at Europe illustrates that several
central banks are already operating with a multitude
of unconventional measures including full-blown
quantitative easing, negative policy rates and also
outright interventions in FX markets.
Chart 4: Europe – unconventional policy at work
Europe
Sweden
Forward guidance


Long term refi operations

Sovereign bond purchases

Non-sovereign bond purchases

Negative policy rates

Switzerland

% of total market volume
50
0.375 19
0.50
Primary objective
Easier financial
conditions

FX interventions
25
Denmark




Weaker currency
1,0
38
28
16
25
0,5
0
0
–0.10
–25
–0.30
–0,5
–0.35
–0.65
–50
US
UK
JAP
Central bank sovereign bond holdings
EUR
SWE
%
Measure
DEN
–0.75
–1,0
SWI
Policy rate (rs)
Source: Allianz Global Investors Global Economics & Strategy, Bloomberg, January 2016
Note: Central bank sovereign bond holdings comprise current holding (US, UK) and expected holdings
(EUR by March 2017; SWE by mid-2016, JAP by end-2016).
3
Monetary policy divergence – a new transitory regime for global central banks
After having resorted to such a broad array of
unconventional measures, what else could be
done if more stimulus becomes necessary down
the road? The good news is that within the current
unconventional toolkit the effective lower bound
of interest rates has not been tested yet. The
predominant assumption in financial markets
until three years ago was that policy rates could
not be lowered into negative territory, because
banks and depositors would evade the resulting
penalty by converting their book money into cash.
However, there are several reasons why this kind
of cash preference hasn’t materialized so far, even
in countries like Denmark and Switzerland where
the relevant policy rates are currently at –0.65 and
–0.75 %. While storage, transportation and other
convenience costs still suppress the appetite for
cash, commercial banks have also been hesitant
to pass on negative interest rates to their retail
depositors. As the effective lower bound is obviously
below zero and has not been reached so far, policy
makers might feel tempted to reduce policy rates
even more into negative territory, in particular if
they want to engineer further currency weakness.
In a blunt way, that objective may also be achievable
by directly intervening in the FX market. But this
is neither an appropriate global policy tool, as
the beggar-thy-neighbor problem and related
fears of pernicious currency wars show, nor is it a
sustainable strategy for individual countries under
certain circumstances, as the turmoil caused by the
abandoning of the Franc floor by the Swiss National
Bank in early 2015 demonstrates. According to
several research studies, the effective lower bound
of policy rates might be as low as –2 to –3 %.
Furthermore, there is still wiggle room left in
many countries to extend quantitative easing by
deepening and broadening the targeted universe
of central banks’ bond purchases. But the rising
share of sovereign bonds held by monetary
authorities has raised the risk of stronger fiscal and
political interference into monetary policy and
may increasingly compromise the independence
of central banks going forward. The Bank of Japan,
for example, is expected to hold almost 40 % of the
outstanding stock of Japanese government bonds
by the end of this year. No wonder that analysts
and investors have started to speculate if and when
certain central banks might be forced to mull
over some form of hidden debt monetization, for
example by rolling over maturing government bond
holdings on their balance sheet indefinitely.
At the current juncture, this has to be considered
as a “nuclear option” for central banks, not least
due to the prevailing political and legal restrictions
on monetary financing of public debt. The same
holds true for other widely discussed proposals like
the raising of central banks’ inflation targets, the
introduction of so called helicopter money or even
the abolition of cash or the devaluation of paper
money to overcome the limits emanating from the
effective lower bound of interest rates. Nevertheless,
it becomes increasingly obvious that central banks,
while already acting in uncharted territory, may be
forced to deploy even more innovative measures in
the future. But this would not come without risks!
Further unconventional stimulus might, at a certain
point, lead to heightened financial instability and
could finally undermine the trust in the fiat money
system more generally.
Chart 5: Significant divergence between market expectations and median FOMC projections
10
8
6
%
4
2
0
–2
–4
–6
–8
Taylor rate = 3,96 + 1,42* inflation gap (core PCE) + 1,79 * output gap (NAIRU)
1987
1991
Fed funds target rate
pre-GFC Taylor rule
1995
1999
2003
2007
2011
2015
Taylor rate (core PCE, NAIRU)
median projection of FOMC participants
implicit fed funds rate
Source: Allianz Global Investors Global Economics & Strategy, Bloomberg, January 2016
4
Monetary policy divergence – a new transitory regime for global central banks
See Blanchard / Dell’Ariccia / Mauro
(2010), “Rethinking
Macroeconomic
Policy”. Ball (2014),
“The Case for a LongRun Inflation Target of
Four Percent”
1
Box: “Nuclear options” of unconventional monetary policy
Raising of central banks’ inflation target. A higher inflation target, as suggested by several economists
(most notably former IMF chief economist Olivier Blanchard1), would in theory ease the constraints on
policy makers arising from the effective lower bound of interest rates. However, the benefit of more
monetary policy flexibility might be more than offset by the costs arising from higher inflation volatility
and the risk of a de-anchoring of inflation expectations.
“Helicopter money”2. Nobel laureate Milton Friedman laid out the basic principle of a permanent and
irreversible increase of a central bank’s monetary base to finance fiscal stimulus as early as 19693. It’s
essentially like “dropping free money out of a helicopter”.
Abolition or devaluation of paper money. The rising preference for zero-yielding cash in times of
negative interest rates on deposits acts as a limit for more monetary policy accommodation. In order to
address this problem, economists have been discussing several solutions such as a devaluation of paper
money (for example by introducing a stamp duty on notes as initially suggested by the German economist
Silvio Gesell4 more than a hundred years ago), different conversion rates between low denomination
notes / electronic currency and large denomination notes or even the outright abolition of cash5.
The resulting hike and reverse scenario would be
clearly detrimental to many asset classes.
In our central scenario we foresee an increasingly
divergent but globally still highly accommodative
monetary policy environment in 2016. Even those
central banks which are expected to hike policy
rates, in particular the Federal Reserve and the Bank
of England, will deliberately remain “behind the
curve” and leave interest rates way below levels
indicated by their historical reaction functions,
confirming our longstanding “lower for longer”
and “financial repression” investment themes.
But it goes without saying that the uncertain
macroeconomic environment leaves ample room
for monetary policy errors:
Monetary policy exhaustion. Even in countries
where more monetary stimulus is delivered, the
marginal impact of those measures might subside
further or they could become completely ineffective
This kind of monetary policy exhaustion is a serious
concern for policy makers.
Hike and reverse. Central banks might face a
situation in which their economy is incapable to
digest even small rate hikes or in which financial
markets have become so addicted to the liquidity
provision that a policy normalization is impossible.
See Friedman (1969),
“The Optimum
Quantity of Money”
3
See Gesell (1891),
„Die Reformation im
Münzwesen als Brücke
zum Sozialen Staat“.
Ilgmann (2011),
“Silvio Gesell:
‘a strange, unduly
neglected’ monetary
theorist”
4
See Agarwal / Kimball
(2015), ”Breaking
through the Zero Lower
Bound“. Rogoff (2014),
“Costs and benefits of
phasing out paper
currency”
5
Ample room for monetary
policy errors
Expectations mismanagement. Even if central
banks are able to follow their communicated
strategy, they may be unable to steer market
expectations accordingly. We currently observe this
kind of expectations mismatch in the United States,
where money markets are significantly underpricing
the published median rate hike projections by
FOMC participants. This heightens the risk of a rapid
repricing later in the cycle.
See Buiter (2014),
“The Simple Analytics
of Helicopter Money:
Why It Works – Always”
2
Too low for too long. On the other hand, central
banks might just overdo it and maintain their
accommodative policy stance for too long,
disregarding potential inflation risks. This would
subsequently necessitate a rapid tightening of
monetary conditions, which by itself could be
enough to spark off turmoil in financial markets or
trigger a recession. Fed Chair Janet Yellen alluded to
this risk at the December FOMC press conference,
arguing for an “earlier but slow” instead of a “later
but fast” rate hike approach by the Federal Reserve.
Overreliance on micro and macroprudential
measures. Global central banks are increasingly
relying on micro and macroprudential measures to
address financial stability risks and exaggerations in
asset markets nurtured by their easy policy stance.
Those measures are still untested in a crisis situation
and might spell trouble for policy makers if they
don’t work as expected.
5
Monetary policy divergence – a new transitory regime for global central banks
Act
All the uncertainties and risks mentioned above
point to a lower macroeconomic and monetary
policy visibility over the months ahead. As
a consequence, a more tactical and flexible
investment approach seems to be appropriate from
an investor’s perspective. In order to reap attractive
asset returns in such an environment, active
investing remains key.
Imprint
Allianz Global Investors GmbH
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60323 Frankfurt am Main
Global Capital Markets & Thematic Research
Hans-Jörg Naumer (hjn), Ann-Katrin Petersen (akp),
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Allianz Global Investors
www.twitter.com/AllianzGI_VIEW
Data origin – if not otherwise noted:
Thomson Financial Datastream.
Calendar date of data – if not otherwise noted:
February 2015
6
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