Following the end of the first month of 2016, some conclusions can be drawn. It was a difficult month for financial markets and equities and commodities in particular. Concerns about the Chinese economy and a falling oil price was what pushed risk assets and commodities more broadly lower. On the side of the winners, gold and silver had a particularly good start to the year, as did government bonds in the US and Germany.
What is also noteworthy however, is the reaction of monetary authorities. While the authorities in China are understandably engaged in a huge effort to stabilize the country’s currency and stock markets, it was the Bank of Japan that decided to cut interest rates into negative territory. At the same time, the ECB head Mario Draghi has promised a policy review during the next meeting of the Governing Council in March. This has led to rising speculation that some kind of policy loosening could be imminent – although given the failure to rise to expectations during the December meeting, there are doubts on what will actually be accomplished.
One could reasonably argue however, that the data both in Japan and the eurozone have not been as dire so as to justify fresh non-conventional action. Negative interest rates for example are a controversial tool, whose effectiveness and ultimate benefit can be questioned. The experience of countries such as Switzerland and Sweden for example, has not been so encouraging and some economists think that the rates could lead to asset bubbles. Has the deterioration of the economic environment in the past month and a half been so severe as to warrant such unconventional responses? Unemployment in the eurozone has been dropping slowly but steadily since mid-2013 and business surveys have also been holding up relatively positively.
Proponents of further easing often cite the deterioration of the outlook for inflation. Falling oil prices have been worrying policymakers as they push inflation lower at a time when prices are growing at an already sluggish pace. Lower oil prices are a positive supply shock for oil-importing countries and that is something that should not be treated as necessarily a negative. Policymakers would also do well to remember the 1970s, when central banks raised rates in response to inflation brought about by the oil shock. Furthermore, weak oil prices seem to be the result of conscious production decisions by oil-exporting countries and not the result of deficient demand (demand has been growing year-on-year at a healthy clip).
Unfortunately, central banks these days, as ‘the only game in town’ (the title of a recently published book), are taking a more pro-active role that might lead them to overreact to economic and financial events. There is also the suspicion that the current post-crisis recovery is not yet strong enough and even a relatively minor adverse influence such as the negative wealth effect from falling stock prices could drive the economy backwards. In the absence of structural reforms and as fiscal policy is often politically – or even financially – impossible to use, monetary policy makers have been experimenting with tools such as negative interest rates and asset purchases of an expanding array of securities. This is particularly true in Japan and the eurozone, which both desperately need politically difficult structural reforms.
This of course has huge implications for currency markets, as uncertainty with respect to the ECB’s, BoJ’s and the Fed’s next moves can be a key driver of currency moves. In addition, financial market turbulence – although not always connected to the real economy – can also have a big impact on the designs of the three big central banks.