Major central banks are currently facing a credibility issue that could cause damage to their own policy framework and to business and financial decisions going forward. The Fed has been “warning” markets of a rate hike for almost 2 years now, with little to show for. The Bank of Canada’s “warnings” about household debt are now the laughing stock of markets. The European Central Bank and the Bank of Japan have inflation targets of 2%, yet have been well below target or in outright deflation for what is starting to be a long period now, with little credible signs of returning to target soon. This context creates confusion and fuzziness in monetary communications, and it has very real implications for just about everyone. This post is very important... Read it attentively and share the insights!
A super extra short briefer for total beginners
Skip this entire part and go straight to the next section if you know about macro policies... If you never learned about central banks and all that stuff or if you need a refresher, here is a crash course that severely oversimplifies everything, but gives you at least an idea of how it works and will help you get something out of this post...
Central banks are government institutions that intervene in financial markets by changing interest rates. They sometimes also buy financial assets to “pump up prices” by creating demand through massive purchases also called “QE”, for Quantitative Easing, and inject “liquidity” into markets so that more money is in circulation. A central bank can “print” money literally for free: it goes on a computer and it enters “plus 1000 billion” and it magically has 1000 billion dollars to buy financial assets from banks, governments, and other financial institutions. One currency = one central bank = one monetary policy.
The main ones are:
Federal Reserve or “Fed” (currency is USD)
European Central Bank or “ECB” (currency is EUR)
Bank of Japan or “BOJ” (currency is JPY)
These 3 central banks influence all global markets and currencies (even the ones that are not directly related to them). China’s central Bank also has a non-negligible impact, but it’s a long story and I don’t want to talk about it here.
The more classic case is that the central bank changes it’s key interest rate to influence all other rates (it’s a long story), which in turn has an impact on financial asset prices, credit conditions, housing, investment, the exchange rate, production, employment, and inflation.
To understand the role of the central bank, see it as the pilot of a car (or perhaps closer to reality, the “pilot” of a big boat)... if the car (the economy) is “going too fast or accelerating too fast” and is at risk of “getting out of control” (inflation and bubbles), it will hit the brakes by increasing interest rates. The higher interest rates will hit the brakes on credit creation (you borrow less when you have to pay higher interest), which slows down purchases by people and companies, which slows down the economy (the car): employment, production, and inflation decrease. The higher interest rate also has an impact on the currency: when interest rates increase, deposits denominated in that currency are suddenly more attractive globally because deposits pay higher interest... global fund managers want to put some of their funds in the currency with the now-higher rate... demand for the currency increases, which makes it appreciate in forex (foreign exchange) markets and slows down exports, which slows down the economy further and contains inflation even more. This is “monetary tightening” and when the central bank talks about embarking on a tightening cycle, it is “hawkish” (it hunts inflation to kill it like a hawk without pitty for jobs, production, or your mortgage rate).
The same logic applies when the car (the economy) is stagnating or slowing down: to avoid a prolongued slowdown and deflation (falling prices), the central bank hits the gas pedal: it decreases interest rates (or outright prints money), which encourages credit creation, which pumps up spending, production, employment, and inflation. The currency becomes less interesting, because deposits in the local currency are now less attractive and there is more money in circulation (more = less scarce = less value) and the currency depreciates in forex markets, which helps exports and jobs, which add to activity. Eventually production, employment, and inflation increase, and all is good (ahem!). This is an “expansionary monetary policy” and the central bank has a “dovish” stance (it is saving the economy from recession like a dove full of compassion).
Why would we want to avoid deflation (falling prices)? It’s a long story, so just take my word for it...
Economy in bad shape or slowing down (falling production, employment, and inflation) leads to central bank undertaking monetary expansion (dovish stance, or “looser” policy) = decreasing interest rates and printing money to boost employment and inflation = easier credit and currency depreciation...
Economy in good shape or accelerating a lot (rising production, employment, and inflation) leads to central bank undertaking monetary contraction (hawkish stance, or “tighter” policy) = increasing interest rates and removing money from markets (long story – just trust me) to fight inflation = harder credit and currency appreciation...
Just trust me and remember this crash course. Don’t ask questions about all this (it’s a 10-paragraph crash course that “replaces” 5 to 10 full-semester university courses!) and don’t listen to grand plot theories of central banks being under the control of powerful private interests and big bad banks... moving on...
Since interest rates have impacts on all markets (forex, stocks, etc) and on employment and inflation, you now understand why traders, business people, portfolio managers, and many other people are obsessed about understanding where interest rates are going. This takes us to the real subject of this week’s post...
Central bank communication breakdown
The Fed has been “warning” of rate normalization since 2014. When they did so, there was partial unwinding of the global USD carry trade, which had huge (and very predictable) impacts on currencies, capital flows, and stock markets globally.
The Bank of Japan has an official inflation target of 2%, but it seems like a joke and is losing credibility every passing month, since Japanese inflation has an incredibly hard time remaining durably above 1% for any significant amount of time.
The ECB has an official inflation target of “close to, but below 2%”, but is currently in deflation (negative inflation), just like Japan.
The Bank of Canada has been encouraging credit creation with historically low interest rates for a very long time, while at the same time constantly repeating it is worried about household debt, to a point where everyone falls asleep when they talk about it.
On Friday June 3rd, data on US Non Farm Payrolls were weak and that was enough to spur widespread expectations of less Fed tightening than previously anticipated, which hit the USD for a few days. This came after a few other signs of a US slowdown, which already had markets on high alert for confirmation of weakness in US growth, hence of no Fed rate hikes for quite some time (hence a weaker USD).
On Monday June 6, one business day after the US NFP data release, Yellen (the boss of the Fed) signalled to markets that one data point (or even a few) does NOT paint the overall picture and that the overall economy was in relatively good position, suggesting that Fed rate hikes were not off the table just yet. I mentioned this on YourPersonalEconomist facebook page to help people see clearer.
I fully agree with Yellen, by the way. But that doesn’t matter. What matters is that we are in a stop-and-go policy communication mode from ALL central banks, which is starting to look like the classic “crying wolf” story, where the little girl yells out that she is being attacked by a wolf, and it’s never true... then she cries out again and it IS true, but nobody is listening anymore, because she lost all credibility. The extra issue is that Fed talk of tighter policy is hard to believe when you actually look at the data (keep reading)...
Central banks need to get a grip and stop this fuzzy policy making and communication. They have mandates, most of which are either excplicitly or implicitly double: full employment and inflation around 2%.
Of course, monetary policy is always conditional on what is happening and “what is likely coming” in the near term, but if the general picture is that there is considerable slack in the economy and no inflation, why exactly talk about potential rate hikes? (we’ll look into this further down).
But if you actually WANT to raise rates to move away from zero and prepare for the next downturn or to prevent bubbles or for whatever other reason, then it might be wise to go ahead instead of talking about it for years, without anything to show for.
Of course, maybe inflation rates will return to 2% soon, and central banks are just being patient... but maybe not! Deflation (ECB and BOJ) has powerful self-reinforcing feedback loops, and the longer inflation remains far from the promised target, the fuzzier the policy message and objectives.
The Fed is starting to have a credibility problem, as is starting to be the case of many other central banks. If the Fed wants to normalize rates to move away from zero as a precautionary measure, then they should go ahead and do it. But that seems strange to me right now, if I trust their own most recent research about the US economy as it currently stands (see further down).
Fuzziness and stop-and-go messages are not good policy. If I take Yellen’s words seriously (and hopefully I should – she is the boss of the Fed, after all!), then the few signs of weakness have not yet ruled out policy tightening going forward... But this may end up being short lived, if the slack remains as it is now...
The Fed’s headache and the global economy right now
The 3 major monetary zones are the USA, Eurozone, and Japan. There are no signs of inflation in any of these, and there is deflation in 2 of the 3. Of the 3 zones, the only one with a relatively “OK” economic context is the USA. The Eurozone is doing the split, with Germany roaring ahead aided by ECB expansionary policy, while the rest of the Zone remains in eternal stagnation and deflation and probably needs more monetary expansion. Japan tried to get out of deflation and it worked... for 2 years... but has been in deflation for 15 of the past 20 years.
The US economy seems to still have a negative output gap, as is clearly indicated by the Fed itself in its own overview of the US economy. Here is a snapshot of that excellent overview of the US economy, provided by the New Yord Federal Reserve Bank (which is known to Yellen and all FOMC members, you can be sure of that!)... I will comment on these graphs further down...
Slack in the economy:
Global demand for US exports:
My 2 cents
There is no inflation in sight in the USA, or anywhere else. The output gap is still negative (there is slack in the economy). There are relatively clear signs of a non-negligible slowdown, from a negative gap standpoint. Investment is slowing down and capacity utilization is not in overheating territory. Global growth is slowing and global demand for US goods is slowing as well, especially with the lagged effects of USD appreciation of 2014-2015. Fed Funds rate is close to zero. Alhtough exports to GDP ratio is small for the USA, a USD appreciation would hinder net exports and would marginally add to downward pressure on growth...
Yellen is walking on thin ice right now! No wonder communication is hard... Any extra softness would quickly force the Fed to embark on QE again, because the interest rate is very close to zero. An unexpected rate CUT would cause widespread panic. A rate hike would give breathing room (further from zero), but could tip the scale and cause the first domino to fall...
Bottom line: Fed talk of tightening is hard to believe, but maybe it could happen after clear indications, if they really want to move away from zero asap. Keep your eyes and ears on high alert! LOTS of market action coming your way for the rest of the year...
But of the 3 main monetary zones, the only one that has a tightening bias is the Fed, because they have positive (but low) inflation and relatively “OK” labor market conditions (even if the participation rate and employment rate both bombed after 2008 and never really recovered).
ECB and BOJ may soon have a QE bias, while the Fed may simply stay put. Given the safe haven status of the Yen, there may be Yen appreciation unless the BOJ steps in aggressively. Central bank communications are always important, but I would dare say that they are of special importance for the next few months. FOREX action will largely depend on the relative evolution of macro fundamentals between these major blocks. Get your fundamentals straight, and keep an eye on key technical indicators.
As for the others: UK, Canada, Australia, New Zealand, Switzerland, and a few others... I’ll leave it for another time... you have enough to digest in this post ;)
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