It’s all up in the air with central banks

Have the central banks become sources of confusion for investors? We may well think so after comments by the president of the European Central Bank Mario Draghi, and the governor of the Bank of England Mark Carney. At the ECB conference held during the week of June 26, both made comments suggesting a swift change in the two institutions’ policies.

Mario Draghi referred to above trend growth in the euro area to imply that the ECB should factor this in when deciding on its strategy. He stated that “deflationary forces have been replaced by reflationary ones”, and listeners instantly took this as a sign of the end to monetary accommodation with the beginnings of tapering at a specified date. This prompted a surge in the euro against the dollar and a swift rise in long rates. The ECB indicated that this reaction was too forceful and that investors had over-interpreted the president’s comments.

Meanwhile at the Bank of England, Mark Carney hinted at an interest rate rise by the central bank, having displayed quite a different stance just a few days before. At the latest Monetary Policy Committee meeting, the Canadian governor of the Bank of England had left the policy stance unchanged, leading to a rise for sterling and the 10-year interest rate.

We can make a number of comments on these developments:

1 – Is this a test run, a way of indicating to investors that monetary policy accommodation will come to an end at some point in the future? This is one possibility, but it is a bit of a conventional explanation, as everyone knows that improving economic conditions mean the gradual end to monetary policy accommodation. And if this is the justification, then why do it now and what is the reason? By the looks of things, there isn’t a reason, particularly as Draghi has at no time given a timeframe for tapering.

2 – At the ECB, Draghi had stated at his last press conference that a change in policy was dependent on convergence of inflation towards the 2%. Is there anything to suggest that this target will be reached sooner than expected?

3 – At the Bank of England, the interest rate question is more controversial as the last MPC voted by 5 to 3 to keep the Bank Rate unchanged, a two-vote gap. Carney argued in favor of maintaining the rate. The only explanation is that the governor aligned with the profile expected by the BoE on the temporary and limited impact of Brexit on the UK economy. If this indeed is the case, the central bank will have to hike its Bank Rate within a certain timeframe. However, a swift recovery in the UK is not the most likely scenario.

4 – In my view, investors are overreacting to the ECB’s stance. They have been expecting tapering of the asset purchasing program with a certain timeframe for quite some time already and Draghi’s comments may have encouraged them to maintain this stance. This is based on a technical reason – inadequate supply of eligible securities. In Germany and some other countries, the amount of available assets will raise problems unless the rules are changed. This is why it will soon be necessary for many investors to drastically cut back their securities purchase amounts.

5 – But this technical explanation is inadequate. The economic cycle is not yet robust enough to warrant a change in the pace of monetary policy. Private domestic demand only got back to pre-2008 crisis levels in the first quarter of this year. Trying to change investors’ projections by sowing the seeds of swift interest rate hikes in their minds means taking the risk of creating a negative impact on economic activity. This argument, based on the asymmetry of monetary policy, which was the Fed’s argument for a long time, must also be that of the ECB. An increase in rates or expectations of a hike would be damaging for growth and the ECB does not want to, and should not, take this risk, especially when inflation is so low (1.3% in June).

6 – It is in no-one’s interests to change economic players’ expectations too quickly. In May 2013, Bernanke rashly called for monetary policy normalization as the situation had improved in the US, but quickly backtracked after the ensuing taper tantrum, with US interest rates rising, particularly mortgage rates. I should imagine that the ECB took note of investors’ behavior in this particular situation.

Conclusion

The ECB is set to keep its interest rates very low for such times as inflation remains below 2% and growth has not sufficiently taken root. Inflation will not pick up before 2019 when wage pressure is set to drive it up. The central bank will cut back the amount of its asset purchase program in 2018 in order to factor in the economic improvement, but I do not think it will set an end date for the program. As is currently the case, it will indicate that the end of the APP will be contingent on long-term inflation expectations reaching 2%. If this condition is not met, it will probably continue its program but with smaller asset amounts. Investors’ over-interpretation of Draghi’s comments also showed that any swift rate hike is naturally checked by investors keen on higher interest rates making a massive return to the markets. I am therefore not convinced of a rate rise for now.

In the UK, monetary policy choices are between a persistent shock on economic activity and an acceleration in inflation. The BoE had decided to limit the impact of the economic shock in the short term while setting the UK on a cyclical recovery course after the temporary negative impacts of Brexit. This is the reading we should make of Carney’s comments, except that the effects of Brexit will be longer lasting and more painful than the UK authorities expect.

The European Central Bank should not act too soon as European economies have not yet stabilized. There will be policy changes in the future, and they should be welcomed, but it is too early to set a timeframe and the profile for asset prices. Recent market shifts therefore reflect an overreaction rather than a change in trend.

This is my weekly column for Forbes. You can find it here in French

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