Three years after the 2009 recession, the global recovery is faltering. Policymakers, particularly in developed countries, are under pressure to act. Given concerns about the sustainability of public debts, in the West the onus remains on central banks to do the heavy lifting through monetary easing. But while further monetary loosening is on the cards on a global basis—via mainly unorthodox tools in the West and modest interest-rate cuts in emerging markets—such measures will have a limited impact on economic growth.
In countries where policy rates are close to zero, the scope for further cuts is limited. Instead, central banks are extending unorthodox monetary measures, the most important being quantitative easing (QE) whereby they expand their balance sheets through asset purchases. The Bank of England (BOE) took this course in early July when it responded to persistent economic weakness in the UK by announcing an additional £50bn (US$78bn) in government bond purchases. This will take the BOE’s holdings of gilts to £375bn (around one-third of the entire stock of government bonds).
In the US the Federal Reserve has refrained from expanding its QE programme since mid-2011. Instead it engaged in a so-called “Operation Twist”, whereby it lengthened the average maturity of debt in its portfolio by selling shorter-term debt and using the proceeds to buy debt of longer maturities. This, together with a verbal commitment by the Fed to keep short-term rates low until late 2014, has contributed to record low yields on long-dated US Treasuries and hence on mortgages which are linked to such securities.
In light of the loss of momentum of the US economy during the first half of 2012, some market participants are expecting the Fed to reactivate QE, perhaps as early as September. The Federal Open Market Committee appeared to validate these expectations at its meeting in early August. It expressed a clear easing bias, saying that it was ready to provide further accommodation if needed. Much will depend on price trends and the labour market. Inflation has subsided from 3% at the end of 2011 to 1.7% in June, raising the risk of deflation in 2013. The labour market has been weak recently, although a decent 163,000 jobs were created in July. One factor which could influence the Fed is the proximity of the elections, due in early November. The Fed has traditionally sat on its hands in the run-up to elections out of concern that policy changes could be seen to be politically motivated.
The Fed is under no illusions about the controversy that QE provokes. While most would consider it justified at times of market failure, such as the period after the collapse of Lehman Brothers, when markets froze and banks were unwilling to take on counterparty risk, its continued use today is questioned, even by some Fed governors. Its effectiveness in easing the monetary transmission mechanism is open to doubt. Much of the electronic money created is being hoarded within the banking system rather than being used to ease access to credit for households and firms.
In relation to asset markets, QE certainly has had an impact, encouraging investors to borrow cheaply and invest in higher-yielding, risky securities. But if prices fall back once QE programmes have run their course, QE may only serve to increase volatility. The effect of QE on the real economy via asset prices is also ambiguous. In the US QE2 may have had a positive—if temporary—wealth effect through higher equity prices, but this was offset by a weaker dollar and higher petrol prices.
Exit strategies are another source of concern. Central banks have not engaged in unorthodox measures on this scale before. There are legitimate fears that the vast sums of electronic money being created will eventually fuel inflation. Central bankers claim that they have the tools to guard against a surge in inflation: for example, as well as absorbing liquidity by selling bonds back to the markets, they can pay interest on banks’ reserves, discouraging the creation of credit. But central bankers’ failure to prevent the credit bubble in 2003-07 has dented their claims to prescience. The jury on exit strategies will be out on this for at least a couple of years. At present, even with more QE, the greater risk is that Western economies sink into a Japanese-style cycle of debt deflation.
All eyes on the ECB
Nowhere are decisions about monetary policy as critical as in the euro zone. Given the unwillingness of creditor euro members, led by Germany, to commit sufficient resources to bail-out funds, the European Central Bank (ECB) is the only institution with the firepower to ease the funding pressures on peripheral sovereigns and banks. Until now the ECB has been reluctant to deploy the full might of its arsenal. The ECB’s mandate is narrow: it is charged only with maintaining price stability (unlike the Fed, whose mandate also encompasses employment). And direct monetary financing of governments by the ECB is expressly forbidden by EU treaties.
Within these constraints the ECB has done more than is sometimes recognised. Its traditional hawkishness has prevented it from cutting rates as aggressively as the Fed, but in July it cut its main policy rate to 0.75% and its deposit rate to 0%. The poor economic outlook for the euro zone economy and receding inflationary pressures will give the ECB cover for further cuts in the second half of 2012, including possibly a shift to a negative deposit rate. We forecast a 25-basis-point cut in the policy rate to 0.5%.
But the main channel of further monetary easing will be via an expansion of the ECB’s balance sheet. This has already been swollen by extensive provision of liquidity to the region’s banks and by the Securities Market Programme (SMP) whereby the ECB purchased, on secondary markets, the bonds of stressed sovereigns. The ECB justified these purchases of government bonds on the grounds that the monetary transmission mechanism was not working (ie, cuts in short-term rates were not feeding through to long-term borrowing costs for some countries).
The SMP has been in abeyance during 2012. In early August, as unsustainably high borrowing costs for Spain and Italy again raised concerns about the viability and very survival of the euro, the ECB’s president, Mario Draghi, indicated his willingness to reactivate it. But he made clear that he would do so only if stressed sovereigns apply for euro zone bail-out funds, which in turn will necessitate political commitments to reforms. It remains to be seen whether the Spanish and Italian governments will be willing to do this, although the markets could eventually force their hands. If the ECB does reactivate the SMP, Mr Draghi’s statements suggest that it may adopt the “big bazooka” approach, cowing the markets by its theoretically unlimited capacity to create money. Previous rounds of the SMP failed to reduce bond yields for any length of time. By stating at the outset that it was only prepared to buy bonds in limited quantities, the ECB had simply provided an opportunity for bondholders to exit from their positions at higher prices. Mr Draghi will not want to repeat this mistake.
More rate cuts in emerging markets
Unlike in the West, where near-zero policy rates mean that further monetary easing has to come chiefly via central bank balance-sheet expansion, emerging-market central banks have some scope for interest-rate cuts. In contrast to the negative real rates prevailing in the West, real interest rates are marginally positive in emerging markets. And inflation has been subsiding in recent months, providing less of a bar to monetary easing. This trend is likely to continue as soft global demand offsets the inflationary impact of poor harvests on food costs in the coming months.
The Economist Intelligence Unit expects a number of emerging markets to cut interest rates in the second half of 2012, but the extent of any cuts will be modest. The Brazilian central bank, which has cut its policy rate on seven occasions (from 12% to 8%) since August 2011, is an outlier, reflecting circumstances specific to Brazil. We expect the Chinese central bank, which has made two cuts in recent months, to complete its easing cycle with a 25-basis-point cut during the third quarter. Inflation has come down to 2.2% in China from more than 6% a year ago, but the authorities will be cautious about easing too much given fears of reinflating a property bubble. In India, where inflation remains stubbornly high, we do not expect any more cuts until early 2013.
No panacea
In conclusion, we expect more monetary easing in the coming months, in the form of central bank balance-sheet expansion and interest-rate cuts. This monetary easing will provide some relief, but we do not expect it to galvanise the global economy. Interest-rate cuts in the emerging world will be modest, and diminishing returns have already set in on unorthodox monetary measures. The West’s problems (high unemployment, creaking infrastructure, unsustainable healthcare and pension costs, and the need to move to greater federalism in the euro zone) are structural and not amenable to monetary fixes. Solutions require political compromises which are proving elusive amid polarisation in Washington and the stand-off between the creditor core and debtor periphery in the euro zone.
