Fixed exchange rates limit the degrees of freedom for policymakers. The breakdown of Bretton Woods in 1971 removed this constraint on official action, and the results were larger budget deficit and higher inflation. The zero bound on interest rates also posed a constraint on behavior. Until this year, despite the long struggle against deflation, the Bank of Japan never instituted a negative policy rate.
Since the early days of the Great Financial Crisis, some had warned of limits of monetary policy. Many investors, analysts, and journalists argued that the world had entered a liquidity trap, and monetary policy offered no way out. It would be pushing on the proverbial string, they argued. Japan was the future.
Such grim scenarios were premature. Ideological constraints were relaxed. A new playbook was written. Unorthodox policies become, well, the new orthodoxy. From the Great Depression, the federal government's balance sheet became a permanent way to underwrite aggregate demand. Government purchases account for a third to half of GDP through the high income countries. From the Great Financial Crisis, the central bank's balance sheet was employed to expand the quantity of some measure of money when the zero bound of interest rates was respected.
We anticipate the size and shape of central bank balance sheets will be a semi-permanent feature for years to come. As the situation stands now, it is naive or disingenuous not to appreciate the linkages between fiscal and monetary policy. For example, last year, to service the US debt, the federal government paid about $225 bln.
The Federal Reserve is the single biggest owner of US debt. As is typically the case, the Federal Reserve, like many central banks, returns some part of its profits to the central government. Last year, the Federal Reserve gave the federal government nearly $100 bln. It amounts to cutting 40% of the government’s debt servicing costs.
Understanding the Great Financial Crisis as primarily a debt crisis, fiscal policy (federal government's balance sheet) could not be used in Europe. The EU, ECB, and Germany seemingly prescribed pro-cyclical fiscal policy. Despite the economic shock, governments were forced to accept austerity. A debt crisis that could not be addressed by more debt was the push back against a caricature of those who advocated a strong Keynesian response of public investment.
Europe, after an initial half-hearted fiscal effort, has relied on monetary policy. The same is true of Japan, but to a lesser degree. Since 2011, for example, Japan has consistently added a supplemental spending bill in the later part each fiscal year. Moreover, Japan has been very slow to reduce its budget deficit as a percentage of GDP. The deficit stood at 7.7% of GDP in 2009 and had eased to 6.0% last year. The US budget deficit peaked higher and last year was less than half of Japan's.
The US Treasury's semi-annual report on international economy and the foreign exchange market has not accused countries of engaging in currency wars that can be found in some analysts' work and the media. Rather it had cautioned that many countries were relying too much on monetary policy, which needed to be complimented by fiscal policy and structural reforms. The recent G20 meeting picked up on this point.
At the same time, there is wider recognition that monetary policy may have reached the point of diminishing returns. In the popular imagery of an airplane with two engines, fiscal and monetary, fiscal engine has not been engaged, and now it is evident that the monetary engine alone is not going to keep the plane aloft.
Draghi's comment that turned the market on March 10 was that policy rates are likely at the floor. He has said this before, but the market responded dramatically. Before this indication, the market reacted as one would naturally expect after the ECB eased in every possible way. The failure to extend the asset purchases beyond March 2017 was offset by new four-year TLTROs, in which the ECB could pay banks to take funds.
Monetary policy remains very much center stage in the week ahead when five major central banks meet. The Federal Reserve, the Bank of Japan, Bank of England, Norges Bank, and the Swiss National Bank.
Of the central banks, the risk of Bank of England action is least. Osborne's budget, expected to pursue the Tory's austerity agenda, may draw more attention. Although growth is slowing, Osborne is reportedly seeking another GBP 4 bln in savings. Many seem to be uncertain whether the budget is a post-election or a pre-election budget, in the sense that regardless of the outcome of the referendum, a new election may be necessary.
It seems like a cottage industry has sprung up over the past fortnight in designing scenarios of Brexit. Given the seriousness of the potential impact, investors cannot afford to forget that this is a risk scenario, and the base case still is that the UK votes to remain. Under that scenario, the possibility of a BOE rate hike toward the end of the year may be under-appreciated. The labor data in coming week will show continued strength in the labor market and preliminary signs that the slowdown in the average weekly earnings may be ending.
The chances of an SNB policy response to the aggressive and multifaceted easing of monetary policy by the ECB seem minimal. The franc is broadly steady against the euro, which has been the SNB's concern in the past. Since last August, the euro has traded in the CHF1.07-CHF1.12 range. It finished last week in the middle of that range and above the 100 and 200-day moving averages. Deflation pressures appear to be gradually easing, and the a slow expansion is gaining traction.
Norway's Norges Bank is the most likely of the central banks to cut interest rates. The deposit rate will likely be cut from 75 bp to 50 bp. The central bank is responding to the weakening of economy as softer foreign demand and the drop in oil prices poses the immediate challenge. The economy contracted 1.2% in Q4 15 on a quarter-over-quarter basis. The mainland economy eked out a disappointing 0.1% expansion after a flat Q3. And this is being achieved with a 3.3% unemployment rate.
The economy does not appear to be off to a strong start. The manufacturing PMI remained below the 50 boom/bust level in January and February. Last week the government reported that manufacturing output fell 1.0% in January. The consensus forecast was for a 0.1% decline.
Despite the economic weakness, Norwegian inflation is perky. Investors learned last week that the headline rate rose to 3.1%, the highest in nearly three years. The underlying rate, which excludes energy and adjusts for tax changes stood at 3.4% in February. This is the highest level since at least 2000.
The Bank of Japan surprised with a rate cut and the introduction of a negative deposit rate. It came under scrutiny at the recent G20 meeting. It is too soon to adjust monetary policy again. However, the BOJ seems to be moving in the opposite direction of the ECB.
Draghi signaled that should additional monetary support be judged necessary, QE will be preferred over a further push in the deposit rate below zero. The introduction of a negative deposit rate was ostensibly to creating another policy tool to compliment the JPY80 trillion (annual) expansion in the monetary base through asset purchases. The BOJ is expected to confirm the target is being renewed at this week's meeting.
The yen's appreciation will likely blunt the impact of the rise in commodity prices. The BOJ may chose to cut rates again. A recent addition to the BOJ is seen as securing Kuroda's majority. Talk is beginning to surface that the sales tax hike scheduled for next year may be postponed (again).
Separately, Japan will report February's trade balance. We digress to point out this notable economic regularity. Since 1974 without fail, Japan's trade balance improve in February over January. This week's data is expected to extend streak. The February balance is expected to have swung into a JPY396 bln surplus from a JPY646 bln deficit in January.
The Federal Reserve meets and will update its forecasts. Yellen will hold a press conference. At the end of last year, the Fed seemed to have suggested the likelihood of a March hike. In fact, the economy has played out broadly consistent with what it had anticipated. The slowdown in Q4 was temporary, and the economy would return to trend or higher growth.
As long as the labor market continued to absorb slack, which it has, officials could be reasonably confident that core PCE would move toward the Fed's target, which it has. Inflation expectations, as measured by the 10-year breakeven, have recovered from 1.11% in mid-February to 1.55%, which is higher than when the FOMC hiked rates in December.
The global capital markets have stabilized after the rough start to the year. The MSCI World Index of bourses in high income countries has risen nearly 11.5% since February 11. The recovery in the MSCI Emerging Market equity index is even more notable. It bottomed on January 21 and since has trended 17.5% higher and finished at the end of last week positive on year-to-date basis.
Another constraint on Fed policy that got a lot of airplay was the strength of the dollar. Since the end of January, a trade-weighted measure of the dollar has fallen by 4.6%. It has returned to levels seen last October.
The same logic that led the Fed to unanimously hike rates in December, and anticipate that four hikes this year would be appropriate, suggests a March rate hike. However, Fed comments and concern perhaps about lending conditions following the tightening suggested by the senior loan officers survey have suggested a hike is unlikely. The March Fed funds futures contract, for example, is pricing in practically no chance of a hike this week.
When in doubt, the Fed has erred on the side of caution. First with the tapering and then with the first hike. What argues against an April hike is the lack of a press conference. Yellen has indicated that all meetings are live, and policy action can be taken without a press conference.
Nevertheless, given importance of communication, underscored by the Draghi's press conference, the Federal Reserve is likely to still want to explain itself. As we have argued before, a press conference after every meeting, as many other central banks do, including the ECB and BOJ, would actually create more options for the Fed.
The pendulum of market expectations swing away from the idea that the December rate hike was one and done for the Fed. If we assume that the effective Fed funds rate averages 37 bp for the first 15 days in June and that the Fed hikes the range 25 bp, and Fed funds average 62 bp in the second half of the month, then fair value is 50 bp. Before the weekend, the June contract closed with an implied yield 47.5 bp.
If the Fed does not hike rates this week, it will likely keep the market anticipating the likelihood of a hike in Q2. There are two ways that the Fed may communicate this. First, it may acknowledge that risks are nearly balanced. Remember in January; the Fed refused to update risk assessment. Second, the Fed's dot plots could be consistent with three rate hikes instead of four this year. There would simply be an acknowledgment that it was not hiking rates in Q1, but that its underlying assessment had not significantly changed.