Posts tagged ‘quantitative easing’
Market chat on the subject of the eurozone has tended to be rather downbeat over the last few years. Some observers have focused on its benighted wrangling over sovereign debt; others, more recently, on the supposed millstone of deflation. And there have of course been those who have questioned the zone’s very future. Narrative gloom set in well before the double dip recession’s second leg, persisted throughout it (Q4 2011 – Q1 2013) and has continued since. Today, however, the fundamentals are refusing to play ball even more stubbornly than they usually can, when the mood takes them.
Earlier this month we saw the ECB revise its growth forecast for 2015 up from 1.0% to 1.5%. Just this week, consumer confidence in the eurozone hit its highest level since the short-lived spike up into July 2007. And the composite output indicator showed the strongest level of growth since May 2011, before the market crash and pandemonium which dominated the second half of that year.
There are three major reasons for this.
- The euro has depreciated. It has fallen by over 20% against the dollar over the last nine months (from 1.365 to 1.088) and more modestly against sterling and the yen also (-8.7% and -6.5%).
- This real world monetary easing has been matched by the ECB’s first foray into quantitative easing. Dubious though the policy’s concept and effects may be, markets have tended to approve of this.
- The eurozone collectively is the world’s largest net importer of crude oil. Though the euro has got cheaper, oil has got cheaper still: the near Brent crude future is 36% lower in euro terms today than it was nine months ago.
Against this background the strong performance of European equity markets versus their developed-world peers is understandable. (The Stoxx 50 is up by 17% so far this year as against 11% for the Nikkei, 4% for the FTSE 100 and zero for the S&P.) The question is: can it last?
Disaster notwithstanding, the answer might just be “yes”.
The benign effects of cheap oil on the US as another significant net importer are offset by fears over monetary tightening in the face of a galloping labour market. These intensified last week when the word “patient” was removed from the formal description of the Fed’s present monetary stance. The Bank of England is similarly looking to tighten policy at some point as affirmed by Governor Carney only this morning. Before the oil price collapse began to be felt in earnest there were signs of price pressure in these economies and should the collapse unwind at all into the end of this year those signals will get stronger and stronger.
The unemployment rate in the eurozone, by contrast, fell by only 0.6% over the whole of last year to end it at 11.3%. This brings with it all sorts of other problems, of course, but from an inflationary perspective it leaves a lot of slack in the labour market. It looks likely to be some considerable time before investors need to worry about monetary tightening from the ECB.
On a similar note: with oil and other commodities having fallen or – at best – stabilized in price over the last few months, there is little danger of the weak euro having an inflationary effect. At the same time, the pitch of its descent means it has been winning that notorious game of “beggar my neighbour” for its exporters on the major currency markets. (This is not such great news for some far eastern countries, including China, whose exchange rates have strengthened impressively against the euro.)
There are always risks and Europe faces its own particular demons. But the speed of the turnaround there has been impressive: it was only back in November that the EU Commission last cut its forecast for 2015 growth. Like good news, quick turnarounds might well strike readers as a most un-European phenomenon. It has been most welcome to see the Continent delivering such pleasant surprises for a change.
Much like last year, 2015 has got off to an exciting start. This blog identified interest rates as an important market theme, and though the Fed (and to a lesser extent the Bank of England) have been positioning expectations for a tightening of policy at some point it has been the new emergency monetary measures in Europe which have dominated attention thus far. Mr Draghi can take much of the credit for turning around sentiment on the sovereign debt malady in 2012, attracted further limelight last year by introducing negative deposit rates among other things and yesterday, of course, officially announced the start of quantitative easing in the eurozone. As with his other announcements this one has been taken well: the Stoxx 50 has risen by more than 10% over the last couple of weeks, bonds in Greece and elsewhere in the eurozone periphery have found some support and he will not mind that the euro, which has fallen by 3% against the dollar in the last two days alone, now stands at levels last reached in the summer of 2003.
Fears over the prospects for Europe are nowhere near as powerful as they were in the days of the Bond Market Terror when Draghi took the helm in November 2011. Today the fear is that the Continent will follow the “deflationary spiral” which sucked the Japanese economy under the waves for so many years, as people defer spending decisions, companies delay production, activity thus contracts (exacerbating the price effect) and the bells of doom generally begin to toll.
Or so the story goes. The Japanese experience was / is not actually like that. After the collapse of the 1980s economic and investment boom the stock market crashed in 1990, growth began to slow, and the Bank of Japan cut rates accordingly. The yen, however, was allowed to appreciate by over 50% on a trade weighted basis at the same time, more than compensating for this effect and ensuring a recession which saw growth move sideways for two years. Annual inflation, on the other hand, didn’t turn negative until 1994 – and in 1995-6 the economy motored along just fine. The first bout of Japanese deflation was therefore a symptom of the malaise, not its cause.
Then came the 1997 collapse of the Asian tiger economies, the Japanese banking crisis and another unwelcome period of massive yen appreciation. It was at this point that the zero-interest rate policy, “ZIRP”, came along. Then of course there followed the collapse of the TMT boom. So the level of Japanese real GDP moved sideways for five years this time (1997-2002). Although deflation did not begin in earnest until the 2000s, its association with Japan’s “lost decade” had become intractable, and the idea of deflation as a cause of her problems, rather than a symptom of them, an established part of the market narrative.
Looking at this another way, Japan is not the only economy to have experienced deflation in the recent past. Did you know that Switzerland, for example, saw a pronounced deflationary period from 2011 to 2013? Or that Singapore officially entered deflation a month before the eurozone? Nor is it only countries beginning with “S”: Israel has been deflating quite cheerfully since the autumn, joined last month by neighbouring Lebanon. None of these places are forecast to suffer Armageddon as a result.
One could also mention that “core” inflation in Europe remains positive … but by this stage the point ought to be well made.
Of course, a lot of market narratives can become self-fulfilling. For this, if for no other reason, it should come as a relief to see the latest round of “open mouth operations” at the ECB enjoying a positive reception.
As a last word on this subject – for now! – it also salutary to observe what happened to Japanese asset pricing during the first decade of this century. Ten year bond yields did not tend to trade at 0.4%, for example, even with deflation all around, QE in train and the policy rate at or near zero. Nor did equities experience a terminal spiral of death, or the yen perpetually depreciate. But all of that is a much longer story.
There are a number of notable points which could be made about the Chancellor’s Autumn Statement yesterday. The political as well as the economic mood has clearly moved in his favour. Some of the measures announced, like the establishment of a moving target for the state pension age, were substantial. And of course the Office for Budget Responsibility has revised its economic forecasts up, meaning that the forecast level of government indebtedness has come down.
It is not the first time that this has happened. At the time of the Autumn Statement in 2010 and of the 2012 Budget, OBR debt to GDP projections drifted ever-so-slightly lower, with the peak level of indebtedness on a Treaty basis coming down by 0.8% and 1.2% respectively – before shooting up again in subsequent reports. But the difference this time is much more material: back in March, debt to GDP was forecast to peak at 100.8% in fiscal 2015-16; now the peak is to reach “only” 94.7% in the same year.
The full text of the OBR’s Economic and fiscal outlook attributes the difference to higher nominal GDP and lower borrowing about equally over the two years 2014/15 – 2015/16. It is worth quoting the following directly from the text:
While most public discussion of economic forecasts focuses on real GDP, the key driver of our fiscal forecast is nominal GDP – the cash value of economic activity – and its composition. The level of nominal GDP is higher across the forecast period than in March. … Whole economy inflation – as measured by the GDP deflator – is little changed from March.
In recent years there has been some debate about the possibility that governments would try to inflate their way out of debt (e.g.). Some economists even advocated this as policy. Regular readers will know that the idea isn’t a serious one – and the UK’s new numbers give some proof of this. In debt terms, the tide might just have turned, and higher inflation has played no part in this projection.
What we can say is that a little growth goes a long way. While the forecast for peak debt to GDP has fallen by over 6%, the cumulative change in real GDP to 2015 since the OBR’s March forecast is only +1.3%. As well as growing the denominator of the debt / GDP calculation, higher growth also reduces planned expenditure and increases projected tax receipts, thereby causing the cash amount of borrowing to fall. For economies with uncomfortably high debt, a growth spurt is the best possible cure.
This week’s data from across the Atlantic is warmly encouraging in this regard. US GDP for the third quarter was revised up in the second estimate to 3.6%, right at the top of the forecast range and the highest rate for one and a half years; confidence has rebounded from the blip of the shutdown; and unemployment fell unexpectedly to 7%, its lowest level in five years. (It is interesting to observe that this is the level which, arriving in 2014, was supposed to see the end of the Fed’s QE3. The press conference at which this was announced panicked the markets. So far this afternoon, by contrast, the S&P 500 is up by almost 1%.) If this is all beginning to add up to a proper global recovery it will be the best possible news for indebted developed-world economies.
As always we need to be careful. Reducing borrowing over the medium term will require continued fiscal discipline, and to borrow one of the Chancellor’s phrases, it can be human nature to focus on “fixing the roof” only when we are being rained on from a great height. And we should not give him too much credit either: he boasted proudly that the budget deficit as a share of GDP is expected to have fallen by 11.1% over the nine years following 2009-10. Another way of putting it is that it will have taken nearly a decade of continued borrowing for the UK to have not quite balanced its books again. Back in 1993 on the other hand, when the deficit peaked at 7.9% of GDP, it took only seven years to bring it up to a surplus of 3.5%: a larger improvement of 11.4% in total.
Still, falling government indebtedness is good news, and long may it continue. With a strengthening and prolonged global recovery there is every reason to think that it will.
The release of minutes from the July meeting of the Federal Open Market Committee generated headlines this week. Fears of the effects of “tapering” – the reduction by the Fed of the amounts of fixed income security purchases it makes under its “QE3” programme of quantitative easing – have continued to unsettle markets.
There was no clear steer from the minutes as to when this will eventually begin. But according to research released by the San Francisco Fed earlier this month it doesn’t matter much anyway. The Fed economists who wrote the study estimate that a QE2-sized programme ($600bn of US Treasuries purchased over two years) without accompanying dovish guidance on interest rates would have added only 0.04% to GDP growth and 0.02% to inflation. Even with this guidance they assessed the impact at a meagre +0.13% on GDP and +0.03% on inflation. As they conclude:
Asset purchase programs like QE2 appear to have, at best, moderate effects on economic growth and inflation … those effects are weaker and more uncertain than conventional interest rate policy. This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.
Moreover, one of their key model assumptions was that QE would lead holders of longer-dated Treasuries to reallocate capital to other asset classes or the wider economy (they assume no impact on holders who are indifferent to bond maturities):
If long-term yields fall, these investors have less incentive to save and may allocate more money to consumption or investment in nonfinancial assets. This boosts aggregate demand and puts upward pressure on inflation.
This analysis will be familiar to readers who remember the numbers involved in our own programme of QE here in the UK. As this blog observed some time ago, however, with the government issuing at least as much debt into the bond market as the Bank of England is taking out, this “helicopter drop” monetary model simply doesn’t fly:
Imagine that you were in the crowd underneath the helicopter and had managed to scramble successfully for £50. Then, as the helicopter flies away and you are about to put the money into your wallet, you feel a tap on your shoulder. You turn to see a man standing in front of you with a knife, who mugs you for it. Would you feel like the beneficiary of a windfall and embark on an inflationary spending bonanza, or would you put your wallet away in bewilderment, feeling as if the whole exercise had been an elaborate distraction?
Unsurprisingly for an economy which has seen the level of public debt to GDP rise from a little over 60% at the start of the Great Recession to over 100% today, the same logic applies over the Atlantic. Since the Fed started QE it has bought $2,196bn of Treasuries. Over the same period, BoA Merrill Lynch data on the Treasury and TIPS markets shows that the face value of the US government bond market has increased by $5,251bn – almost two and a half times as much.
So the numbers suggest US QE has been a monetary sideshow, as does a study made by the Fed’s own specialists. The same is also true if we look at other possible transmission mechanisms which the study ignores, such as the weekly Fed data on loans and leases made by US commercial banks for example, which after a prolonged decline only exceeded their previous (2008) peak towards the middle of last month.
This is not to denigrate the Fed’s whole programme of unconventional policy measures. The purchase of mortgage-backed securities alongside government bonds for instance might well have helped repair bank balance sheets – as well as contribute to lower mortgage rates, and alongside the effect of initial emergency measures such as the Troubled Asset Relief Programme, the Federal takeover and capitalisation of Fannie Mae and Freddie Mac, etc. In fact the speed of the banking sector recovery in the US – as opposed to in Europe (including the UK) – has been one of the great relative strengths of the American economy. The Fed’s activities during the subprime crisis and its devastating aftermath are not to be sniffed at.
Nonetheless, some participants are betting that ending, or merely reducing, a programme whose actual monetary effects are likely to have been trivial will destabilise economic recovery in the US and across the globe.
This appears to betoken an unreasonably heightened level of concern.
On Wednesday, Fed Chairman Bernanke held a press conference. Making it clear that (in his phrase) the Fed would be “letting up a bit on the gas pedal” rather than hitting the brake, he announced that asset purchases conducted under the quantitative easing programme would likely start tapering off this year if the US economic recovery continued to show strength.
So far, so reasonable. QE is an emergency monetary measure designed to stimulate growth in desperate times. If the times no longer look desperate emergency measures are no longer required. Mr Bernanke’s announcement was a signal that the Fed’s view on the recovery has grown more positive. Some might describe that as good news.
Markets, however, did not see things that way. For them the story was the oncoming shrinkage of central bank stimulus. Since QE involves bond buying, bond markets sold off with the 10 year US treasury yield up about 30bp since the end of last week. Since some participants in the rather confused rush into owning gold had bought the metal out of fear that the QE programme would usher in hyperinflation and dollar collapse, gold continued its fall, closing below $1,300 an ounce for the first time in almost three years. And equity spiked lower again: the S&P 500 dropped by 2.5%, its biggest one-day fall in percentage terms since November 2011 (when Italy was thought to be on the edge of default), and losses in Europe were even worse.
Much of this behaviour is defensible in logic. But the reaction is also interesting for what it tells us about sentiment.
Back in the panic of H2 2011 the Fed got a similar bashing from markets when it announced a change to its QE programme. It wouldn’t be buying a greater quantity of bonds outright; it would simply be lengthening the maturity of the programme to move longer as well as shorter term interest rates lower. Dubbed “Operation Twist”, readers may remember that the market lurched lower – not because it didn’t like the idea but because the economic view put forward by the Fed as justification for the move was surprisingly negative.
In other words, just the opposite happened in 2011 as happened this week. Then, the market ignored the Fed’s intention to increase monetary stimulus and focused on its gloomy assessment of the economy. Now, the market is ignoring the more constructive economic view and focusing on the intention to reduce monetary stimulus.
This week’s stock market reaction has been bearish. Not as bearish as it was in September 2011: then, the fall after the Operation Twist announcement was 6%, not 2.5%. But it is bearish nonetheless. An American stock market which rallied on the back of the most consistently positive economic data period for some years has now fallen as the chairman of the central bank expressed a cautious view that this period would continue.
It is foolish to be dismissive of sentiment. Operation Twist succeeded in driving US mortgage rates to new lows, and housing market activity has picked up ever since. If bond market fears deepen and long term rates continue to go higher, some of that shine could be taken off over the next few months. But it is undeniable that fear is more rational at some times than at others.
During 2011 the US labour market was stalling, the Greek crisis brought fears of catastrophe in Europe and China was tightening monetary policy to contain an inflation problem. Today the US economic picture is so much more obviously confident as to be almost unrecognisable, the “European crisis” has not been remotely as bad as feared and the Chinese are keener to promote growth than stifle it.
Markets are equally in a much happier condition than they were two years ago. As a result, the opportunities are not quite so obvious as they were back then. But episodes like the current period of bearishness can still create them – with or without the help of press conferences from central banks.
This week saw the publication of “advance estimate” (first stab) UK GDP data for the final quarter of last year. As expected it showed a setback, with output down 0.2%.
This was inevitably reported to be a disaster. Her Majesty’s loyal opposition blamed the government’s not-terribly-drastic austerity programme; the Chancellor blamed goings on in the eurozone.
The real culprits are more likely to have included a stronger pound, with trade weighted sterling over 4% stronger over the second half of 2011, and the continued squeeze on real incomes arising from Britain’s unusually high rate of inflation. (The latter effect in particular goes a long way to explaining why the recovery in our GDP since the bottom of the recession in 2009 has not only lagged that of the US but also that of Japan and the eurozone.)
Be that as it may: if the eurozone is not yet finished, neither are we. Last year began in similar circumstances with a -0.5% fall in GDP reported for Q4 2010. It proved to be transitory. And other data released over the last few days also suggest an economy which is experiencing a bump in the road to recovery rather than a fall over the cliff into serious recession: retail sales growth of 2.6% in the year to December was stronger than expected, BBA data on mortgage lending continued to post a modest improvement and industrial orders data for January saw a welcome bounce.
Most importantly, data on government borrowing – specifically the figure for public sector net borrowing excluding financial interventions, “PSNB ex” – was stronger than expected despite the weak outturn for GDP. According to the Office for Budget Responsibility, the UK may now even be on track to outperform its debt target for the current fiscal year.
None of this is to suggest that a contraction in GDP, however slight, is good news. Apart from anything else the data could well trigger another cavalier display of pointlessness from the Bank of England in the form of more “quantitative easing“. Nor does it alter the fact that the UK’s debt burden is an ugly one and that we have been lucky so far in that bond markets have given us the benefit of the doubt. But there is a world of difference – here and elsewhere – between standstill and collapse. Markets are beginning to bet more on the first than the second of those alternatives. This week’s data from the UK suggests that they might be right.
So Mervyn King and his team at the Bank have decided to carry on easing. Widely misrepresented by the shorthand of “injecting money into the economy”, we have looked before at what “quantitative easing” really entails and at the negligible effect it has had.
The justification supplied this time for the £75bn programme is that the UK economy has been growing terribly slowly and that it faces a serious financial crisis. Which is all very interesting, but is supposed to be secondary to the Bank of England’s mandate to keep prices stable, defined at present as delivering annual UK CPI inflation of 2.0%.
The Bank still pays lip service to this notion in a quarterly document it puts out called the Inflation Report which updates readers on its view of the economy and justifies whatever its current monetary stance happens to be by reference to its forecast for inflation. In November 2008, for example, when the base rate was cut by 1.5% (to 3.0%) in the wake of the Lehmans collapse, CPI was predicted on the Bank’s model to reach a woeful 1.0% by Q4 2010 (p. 47). In actual fact inflation averaged 3.4% over that period.
Now the end of 2008 was a rare old time. The financial system as we’d come to know it had burned to the ground, the world economy was in recession and stock markets were stampeding towards zero. Sterling had fallen sharply too. The Bank was on its way to a base rate of 0.5% and £200bn worth of bond purchases. So let’s look at the Inflation Report forecast of August 2009, at a time when the economy was returning to growth, stock markets were rallying, the pound had found a new level and the MPC had had nine months in which to refine their projections. Even with the unprecedented monetary stimulus, they said, inflation was going to fall steadily during the course of 2010 to about 1% before rising to a gentle 1.5% by August 2011 (p. 42).
Of course what happened was that inflation doubled over the next six months, has risen steadily since and by this August (the last count) stood at 4.5%. This level of inflation has decimated real wages and contributed to a double dip recession in the household sector. And it has proved the assumptions underlying Britain’s emergency monetary measures woefully wrong.
The Bank, in other words, has shown itself damagingly incapable of forecasting UK inflation. Another Inflation Report is due out next month. It is bound to project the return of CPI inflation to 2% in two years’ time – or even an undershoot requiring more QE. And who knows? Perhaps in August of 2013 we will have economic contraction, price inflation of 8% and Mr King’s successor throwing wads of fifties off the roof of Threadneedle Street, wondering why it all keeps going wrong.