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View related content: Monetary Economics
With the way central bankers have been behaving over the past month, you would think global inflation is picking up, economies are booming, and financial bubbles are inflating further. Nothing could be further from the truth. Central banks all over the world ought to leave well enough alone rather than raising already-elevated uncertainty with talk of phasing down (“tapering,” in US parlance) quantitative easing (QE).
Key points in this Outlook:
Markets threw a taper tantrum after the Federal Reserve’s June 18–19 policy meeting. Fed Chairman Ben Bernanke’s agonizing hourlong post-meeting press conference, a forum added a couple of years ago to help clarify the Fed’s message on monetary policy, only made matters worse.
Bernanke tried to explain how and when an eventual possible tapering of QE might play out. All the market heard was “tighter money.” During the following 48 hours, stocks fell by 4 percent and bonds were sold as interest rates rose, with five-year rates rising by 30 basis points and flattening the curve as 30-year yields rose by 20 basis points. The dollar strengthened, again a sign that markets believe tighter money is coming, and soon.
This is getting ugly. The US economy is weak, growing at probably less than a 1.5 percent rate while inflation is dropping steadily toward 1 percent. The Fed is not supposed to be sending a tightening message now because that risks slower growth and deflation that will only push stocks and house prices back down. Premature monetary austerity is more dangerous than the premature fiscal austerity visited on Europe in 2010–11. Now, fiscal austerity is much criticized, but soon, monetary austerity will be even more unpopular, and the Fed will be talking about untapering.
Confusing words from central bankers beginning with Bernanke’s May 22 testimony and his June 19 press conference have failed to clarify the “taper” path on QE and have boosted market volatility and real interest rates at a very bad time, just as most major economies are stagnating (United States and Japan), slowing down (China), or in outright recession (Europe). (See figures 1 and 2.) Emerging markets are struggling too, especially Brazil and Turkey, where rising inflation and cutbacks of government services have prompted riots and spooked investors even further. (See figures 3 and 4.)
Through all of this turmoil, inflation keeps falling in the United States, Europe, China, and Japan, something that happens when substantial excess capacity forces price cutting. If anything, central bankers may need to talk about more accommodative policies, not less.
It seems almost as if the world’s leading central bankers met secretly and decided it was time, facts aside, to begin exiting their highly stimulative policies. Mixed messages have come from central banks in Japan, Europe, and China just as Bernanke’s taper trauma has emerged to plague US and global markets. This has sent interest rates higher and sharply increased market volatility just as US inflation and inflation expectations by virtually every measure have dropped substantially. (See figures 5 and 6.) US economic data have indicated modest economic growth, probably around 1.5 percent at an annual rate during the second quarter, while year-over-year inflation measures have dropped to 1 percent, well below the Fed’s target of 2 to 2.5 percent. Core PCE (personal consumption expenditures), a favorite Fed inflation gauge, has dropped to the lowest level in its 50-year history. (See figure 7.)
Global Weakness Compounds US Taper Pain
At least Bernanke is thinking about changing monetary policy in an environment of positive growth and no deflation. After promising on April 4 to take a more aggressive expansionary stance for monetary policy and fiscal policy and move toward structural reform, the Bank of Japan has hesitated as volatility in the bond market has made it nervous. The plan was that the Bank of Japan’s announced plan to boost inflation to 2 percent while creating an environment of sustained growth would cause many banks and households to want to sell their government bonds. The real stimulus would come from the Bank of Japan’s buying all the bonds on offer at prices that implied that long-term interest rates would stay low.
Instead, the Bank of Japan has hesitated, perhaps having underestimated the amount of support it would have to provide for the bond market. But its hesitation has created uncertainty, and the rally in the stock market has been sharply reversed. Stock prices have fallen by over 20 percent since May 22 although Japan’s currency has strengthened by about 7 percent, mitigating the stimulative effect on inflation and exports that a weaker currency was supposed to provide. (See figure 8.)
At its meeting in early June, Bank of Japan Governor Haruhiko Kuroda failed to provide any new guidance for markets, and stocks continued to languish while the currency continued to strengthen. Meanwhile, Prime Minister Shinzō Abe discussed his government’s proposals for structural reform, which were supposed to be part of Japan’s recovery package, in a muddled way. He did not provide needed reassurance to already skeptical markets that Japan could actually accomplish fundamental structural reform, including introducing more competition in Japan’s notoriously inefficient agricultural sector.
Not to be left out of the central bank “stingy club,” European Central Bank (ECB) president Mario Draghi indicated after his group’s June 6 meeting that, contrary to his prior statements of reassurance, he felt the ECB had done about all it could to keep Europe’s economy moving while stabilizing financial markets. The ECB pivot from extra to less accommodation has actually caused the euro to strengthen modestly, undercutting any chance for an economic boost from central bank policies through higher exports. Meanwhile, European auto sales have dropped to 20-year lows, and most European economies continue to languish.
Europe’s May inflation rate was a low 1.4 percent year-over-year, making it part of the global disinflation club. Unemployment remains at record levels in southern Europe, and political resistance to further austerity has continued to build to a point where, individually and collectively, governments are advocating an end to austerity even while criticizing the United States for imposing some fiscal austerity earlier this year. Soon they will, with good reason, be critiquing the Fed’s shift toward monetary austerity.
The world’s second-largest economy, China, joined the central bank stingy club in June. With a sharp drop in the inflation rate over the past several months and weakening industrial production, the central bank of China, the PBOC, has elected to allow China’s (interbank) money market rates to spike from just below 4 percent to 7–9 percent by restricting the flow of funds to banks. China’s big banks are starting to reduce the bond offerings (borrowings) they employ to raise money to finance China’s economy. And the country’s real estate sector has frozen with a substantial volume of unoccupied investment apartments still available for sale.
More broadly, China has started to suffer from excess production capacity, a hangover from the sharp stimulus its government administered in 2009 to stave off the effects of the financial crisis on its economy. Huge flows of credit were made available and large public- and private-sector investments were made, and now the new capacity, along with a large stock of new apartments, is coming on stream without much demand for any of it. As a result, prices are being cut, especially in a world where the global economy is slowing and competition in the export sector is becoming more intense.
Beyond that, Japan’s effort to stimulate its economy by sharply weakening the yen has contributed to the strength of China’s trade-weighted currency and, thereby, a slowdown in Chinese exports. Europe’s slowdown has compounded the negative impact on China’s exports and enhanced excess capacity while depressing prices.
The broad-based withdrawal of maximum accommodation by the four major central banks in the United States, Japan, China, and Europe has taken its toll on emerging markets that have—until this year—benefited mightily from the highly accommodative policies in these four economies. As already noted, one of the largest of the emerging market economies, Brazil, is in serious trouble. A government unfriendly to investment has stymied the nation’s supply growth, while a slowing global economy, especially weakness in commodity prices, has harmed its export sector. The Brazilian currency is weakening, the stock market has dropped 20 percent so far this year, and interest rates have risen sharply because of fears about rising inflation and in sympathy with the sharp rise in real interest rates in major economies.
Deflation Risks Reemerge
The important thing to realize is that the rise in market interest rates combined with falling actual and expected inflation signals a sharp rise in real interest rates that could seriously jeopardize even the tepid pace of the US recovery while intensifying Europe’s recession and throwing China into a sharper slowdown. The same holds true for Japan. If Japan cannot conquer its deflation, high or rising interest rates will continue to hold back the economy and recovery in the Japanese stock market.
The details of the US interest rate picture illustrate the interest rate picture globally. Since early April, real interest rates on US 10-year Treasury notes, a sort of benchmark, have risen from -0.8 to about 0.5. (See figure 2.) Although low real interest rates are normally stimulative, in the post–financial crisis environment, it has been necessary to keep real interest rates negative to support economic growth and avoid disinflation that might turn into deflation. Falling actual inflation, a sign of economic weakness and excess supply, has contributed to a rise in real interest rates. When the yield on 10-year Treasuries rises from its late-April low of about 1.7 percent to a mid-June level of 2.4 percent, that 70 basis point rise combined with a half percent drop in expected inflation produces the sharp 1.2 percentage point rise in expected real interest rates.
Some have argued that the rise in US expected real interest rates is good news, a harbinger of higher economic growth. They reason that as growth rises, investment outside of less-risky Treasury bonds becomes more attractive and investors sell their Treasury bonds, pushing up real interest rates. Under this view, the rise in real interest rates is a sign of future strength, rather than a threat to future strength.
One wishes that this were true, but there is little evidence of an accelerating real growth rate for the United States or anywhere else. The Fed is eternally hopeful, forecasting a 2.2 to 2.6 percent range for growth for 2013 and a much-improved 2.9 to 3.4 percent growth rate in 2014. Unfortunately, the Fed’s economic forecasts for the United States have been consistently too optimistic, with the growth rate in the current quarter looking to be about 1.5 percent. There are no compelling signs, like pickups in investment spending or relief from fiscal drag, of stronger growth in the second half of this year. The market consensus for future US growth is well below the Fed’s. (See figure 9.)
The Fed’s abandonment of the highly accommodative stance it enacted with the undertaking of QE3 at the end of 2012, including statements that it would be willing to tolerate inflation rates as high as 2.5 percent to help push down the unemployment rate, needs to be reversed. If not, the higher interest rates and the elevated levels of financial and real uncertainty that have accompanied the Fed’s apparent policy shift could push the United States back close to or into recession. In a world where Europe is already in recession, Japan is struggling to exit deflation, and China is teetering on the edge of slower growth, that outcome would be disastrous.
Too Soon for Talk of Monetary Austerity
If US growth stabilizes or picks up, the global economy may look forward to a much better 2014 with help from improved export demand and more stable financial markets. But by prematurely focusing markets on tapering, the Federal Open Market Committee (FOMC) and Bernanke have created a near panic. QE must end eventually, but why start signaling “tapering” now? US growth is below trend at 1.5 percent, and inflation is falling so much that one FOMC member, James Bullard, “who believed that the committee should signal more strongly its willingness to defend its inflation goal in light of recent low inflation readings,” dissented from the June 19 FOMC statement.
The damage from the uncertainty engendered by Bernanke’s clumsy effort to clarify the QE exit process could be mitigated by a three-step process. First, Bernanke needs to reiterate that the path of any tapering under QE still depends on the paths of unemployment and inflation. Second, he should remind the press and markets that the last FOMC statement and remarks at his last meeting’s press conference continued to specify exiting either QE or zero interest rates as strictly conditional on a drop in the unemployment rate to 6.5 percent, achievement of sustainable growth, and stable inflation, rather than the falling inflation we are observing. Third, Bernanke needs to reassure markets that, should the economy weaken or inflation fall further in coming months, tapering will not be undertaken and QE may be increased, but if the economy improves, tapering may indeed begin.
Bernanke’s underlying problem remains disagreements among FOMC members on experimental monetary policy. That said, the Fed’s dovish FOMC members—consisting of all but the Kansas City president, Esther George, who dissented from the June 19 FOMC statement for fear that continuing QE would raise inflation expectations—should underscore their commitment to the Fed’s QE policy and the terms under which it will eventually be changed.
It is tempting to suspect that the emerging ambivalence among central bankers at the Fed and elsewhere about the path of monetary policy in the wake of a global financial crisis is tied in some way to their unease that such highly accommodative policies and the negative interest rates they imply cannot continue forever. Of course, that is true. But the corollary of that truth is not that the world’s leading central banks should hint collectively that the time has come to remove extraordinary stimulus just as growth is weakening and inflation is falling.
Europe’s flirtation with fiscal austerity in 2010 and 2011, tied to concerns that large deficits and debt accumulation could not go on forever, ended badly with a collapse of growth in southern Europe. European governments and the International Monetary Fund have admitted openly that the premature fiscal austerity was ill advised and highly costly to the economies harmed by extreme austerity, especially Cyprus, Greece, Spain, Portugal, and Italy.
Now, in 2013, the idea espoused by some that removing some monetary accommodation might have a tonic effect on the economy is just as dangerous and ridiculous as the idea that some fiscal austerity might support growth. Make no mistake about it: right now, tighter money, or the expectation of it, will exacerbate disinflationary trends and movement toward higher unemployment while increasing the volatility in financial markets. Better to leave well enough alone than to risk another global recession.
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