Working through the central bank wolfpack

Central banks across the world seem to be at a crossroads after several years of unconventional policy. Nature's wolfpack hierarchy holds clues to what they may do next.


Charles Darwin formed his theory of evolution in part from his observation of wolves in the Falkland Islands in the 1830s: "There is no reason to doubt that the swiftest and slimmest wolves have the best chance of surviving,” he wrote. Many others have found in wolves some very interesting similarities to people, specifically in the structure of wolf packs and their power hierarchy. Central bank watchers can also glean plenty from wolves. Let me explain.

Minutes of the Federal Reserve’s December 12 meeting and subsequent comments from Fed officials have stirred debate about the future course of monetary policy. Market participants have begun to wonder whether the Fed might end its asset purchases (QE3) earlier than previously thought, and whether a rate hike might arrive sooner than the middle of 2015, despite the Fed’s earlier indications that it would likely wait until then.

These are questions that are probably giving Federal Reserve Chairman Ben Bernanke – Mr Volatility Suppressor – a great deal of angst, because the uncertainty they raise could add to market volatility and make it more difficult for the Fed to prod investors to move outward along the risk spectrum. In turn, the Fed’s effort to boost economic activity could flounder, especially if Washington remains a headwind to economic growth.

Bernanke has his work cut out for him. He must not only contend with the howling and growling of colleagues within the Fed 'pack', but also address concerns among market participants that the Fed is growing weary of its unconventional policies.

In one camp are investors who believe the Fed will raise rates before the middle of 2015 because the Fed’s new policy rule to keep rates at zero for at least as long as the unemployment rate is above 6.5 per cent and inflation is below 2.5 per cent will be triggered before then. Separately, this camp also believes the Fed’s asset purchases could end before the requisite 'substantial' improvement in the labour market outlook, owing to restlessness within the Fed over the costs and risks of its asset purchases. In the other camp are investors who believe the Fed will be on hold for much longer, owing to persistent economic weakness.

The challenge for Bernanke is with the first camp, because the December 12 minutes reveal weariness within the Fed itself over its unconventional policies, citing that 'several' and 'few' at the meeting envision the possibility of an earlier end to asset purchases than market participants had previously expected.

Mind you, those who give weight to the 'several', the 'few' and the 'one', who in the minutes are suggesting an early end to asset purchases, may be assigning power to the powerless: This contingent normally is lacking in power – many are non-voters, they are not Fed governors, nor are they the chair or vice-chair. In other words, in the democratic committee that Bernanke has forged, there will always be "howling wolves.” A better method, therefore, when assessing the views of the 'several', the 'few' and the 'many' is to give them weightings based on their relative power within the Fed. Done this way, the expected path of both QE3 and the federal funds rate is likely to look a lot different than when the participants are given equal weights.

Observing the wolfpack – at the Fed

Making accurate projections about the direction of monetary policy involves a great deal of Fed watching and an understanding of the hierarchy that exists within the Fed, not unlike the one that Darwin saw in the wolf packs in the Falklands.

In a wolf pack, there is a leader – the alpha. Next in the chain of command are the betas, followed by the weakest of the bunch, the omegas, who are often the outcasts of the pack. At the Fed, Bernanke is the alpha, and the betas are vice-chair Janet Yellen and New York Fed president William Dudley, as well as the rest of the voting members of the FOMC. The omegas are the non-voters, who always make some noise.

None of this is to say the omegas, or the howling wolves, should be ignored. After all, just as wolf packs depend on cooperation for survival, the Fed depends on a strong sense of collegiality to formulate the best possible policy solutions to meet its dual mandate on employment and inflation. It is nonetheless important when assessing the end-game for the Fed’s unconventional policies to stay focused on the Fed’s leadership rather than the 'few' and the 'several' whose views are at odds with the leaders of the pack.

This is not to say, however, that a change in policy won’t evolve as a result of either a change in economic conditions or a change in the Fed’s assessment of the benefits, costs and risks of its balance sheet expansion, but the hurdle remains high – high enough for the Fed to continue to successfully suppress interest rate volatility, regardless of a few howls now and then.

ECB: Too much of a good thing – Andrew Bosomworth

From the end of January onward, euro area banks have the opportunity to repay some or all of the €1 trillion in liquidity they borrowed at the ECB’s two long-term refinancing operations conducted last year. These LTROs, which mature in 2015, account for the bulk of excess liquidity in the euro area.

Excess liquidity is the net amount of money lent by the ECB to banks over and above their minimum reserve requirements and net autonomous factors. Because there is so much excess liquidity – about €580 billion by our reckoning – money market interest rates are much lower than the ECB’s 75-basis-point main lending rate. The Euro OverNight Index Average, for example, yields just 7 basis points. How much liquidity banks repay before these LTROs mature will influence both the level of money market interest rates, like EONIA, and the external value of the euro. And how much banks repay will, in turn, depend on the distribution of liquidity in the euro area and the commensurate availability of wholesale funding and investment opportunities to the banks.

The level of money market yields like EONIA thus reflects expectations about both banks’ intentions and ability to repay excess liquidity, as well as expectations for the ECB’s main lending rate, factors that are challenging to separate. Based on the relationship between the level of excess liquidity and the spread between EONIA and the ECB’s main refinancing operation rate (shown in figure 1), we can draw two conclusions about what short-term interest rates are discounting. They are discounting either banks will front-load repayment of the LTROs before they mature in early 2015, leaving no excess liquidity in the system thereafter, or the ECB will reduce its policy rate this year and next before raising it again in 2015 – or some combination of both.


We also think the ECB will remove excess liquidity from the system after the LTROs mature in 2015. While not entirely unthinkable, a continuation of excess liquidity beyond 2015 would imply two more years of a broken banking system and the failure of policy reforms at country and system levels to gain traction; it also ignores the capital gradually flowing back to Southern Europe. Notice how Spain’s regions and the Irish and Portuguese governments are gradually regaining market access. Compared to the cost of wholesale funding alternatives, the ECB is cheap, so rather than a gradual repayment, banks are likely to wait until maturity before repaying all their LTRO funds back. In practice, we think banks will hold on to the bulk of their borrowed funds, but that the ECB will mop up any excess liquidity after they mature in 2015.

We also think the ECB will only cut its policy rate again if France’s and Germany’s economies materially slow down, or if an appreciation of the euro endangers the growth and inflation outlook. The current issue is not the level of the ECB’s lending rate, but the distribution of liquidity. Because the liquidity is fragmented – an excess in northern Europe and a dearth in the south – the transmission mechanism has become dysfunctional. Borrowers in Germany can pay 1.5 per cent for a five-year mortgage but a similar mortgage in Spain or Italy costs up to four times as much. A rate cut will thus do little to help those parts of the euro area most under stress.

So instead of using the blunt edge of a rate cut, we think the ECB may implement laser surgery alternatives to help channel liquidity to those parts of the economy truly in need of it. Preferential collateral standards, capital rules or borrowing rates conditional on loans made to small businesses and households, or guarantees provided by the European Stability Mechanism, for example, could be more efficient ways of easing financial conditions.

Ongoing private sector deleveraging and restoring balance to public finances argue for low growth and inflation. While today’s money market interest rates no longer discount a gloomy state for the euro area banking sector in 2015, the rate at which banks repay the LTROs will influence the pace and strength of the recovery. The more LTRO liquidity banks repay early, the more interest rates and the euro will rise. Too much of a good thing – a return to normal liquidity conditions – could, ironically, end up forcing the ECB to reduce interest rates after all to counteract the deflationary impact of a stronger currency.

BOJ: Increasing political pressure − Tadashi Kakuchi

Political pressure on the BOJ has been on the rise since the lower house elections in December. The Liberal Democratic Party’s landslide victory shifted the power back from the "no growth, income re-distribution”-oriented Democratic Party of Japan to the "pro-growth, corporate friendly” LDP. The new government aims to reflate the economy via expanding fiscal expenditures and demanding further monetary easing by the BOJ. Prime Minister Shinzo Abe has been vocal about the BOJ policy and requested the bank adopt an inflation target of 2 per cent – a level of inflation Japan hasn’t seen in two decades, aside from food inflation in 2008 and a one-off price rise in 1997 driven by a consumption tax hike. At its January 2013 monetary policy meeting, the BOJ bowed to the government and adopted the 2 per cent inflation target.

What will the likely changes be to the BOJ’s policy outlook as a result of the increasing political pressure? In fact, there have been some signs of change already. Recent BOJ minutes suggested that the bank now views the Japanese yen as an endogenous variable that it wants to influence through its policy, which is a big change from BOJ Governor Shirakawa’s previous comments that the currency is an exogenous variable that monetary policy takes as an input. With a weak yen as the only possible route for generating inflation, the bank is likely to expand its balance sheet further to influence the yen. Expected changes in key board members (a governor and two deputy governors) this spring are also likely to prompt a further easing bias. Outgoing governor Shirakawa is a firm believer that the costs of quantitative easing outweigh the benefits, and this resulted in an incremental approach to easing. That will likely change under a new BOJ governor, which is likely to lead to more aggressive monetary base expansion (i.e. more QE).

The market has given a thumbs-up to the new LDP government with the yen weaker so far, in anticipation of reflationary policy to come from both the fiscal and monetary sides. How likely is 2 per cent inflation in Japan, where deflation has been persistent over the last two decades? We remain doubtful that cyclical policy tools alone can achieve that target. We estimate that a 10 per cent depreciation in the yen will result in a 0.3 per cent upward pressure on inflation, so the 2 per cent target will be way too high to achieve solely from currency movements. Japan has been in deflation due to its structural issues, such as low-growth expectations, low productivity in the service sector, a rigid labour market system and an unsustainable social security system, to name a few. With the government unwilling to commit to unpopular reforms, structural breakthroughs are unlikely, and the effectiveness of monetary policy remains challenged.

Emerging markets: Focus shifts to other monetary levers – Lupin Rahman

This year is expected to be one of consolidation for emerging markets, with global factors the dominant driver. We expect most economies to experience a soft rebound in growth as Chinese activity stabilises and European tail risks abate, with any deviations from this baseline driven mainly by the outcome of the US fiscal discussions. At the same time, still-positive output gaps and receding commodity prices should keep inflationary pressures contained and in some cases, moderating downwards.

However, for emerging market central bankers, this does not necessarily mean an easy year. First and foremost, most EM central banks have cut policy rates to historical lows, mirroring the declines in yields in developed markets. In several cases, this has meant reversing – and going beyond – the hikes implemented in 2010, while in others (such as Mexico), it has meant staying on hold at the levels that were implemented at the height of the post-Lehman crisis.

What this means is limited scope for further policy rate easing, either if inflation moderates or in the event of a growth disappointment. The latter may result not only from US fiscal discussions, but also from the structural reduction in global demand, which requires a transition away from export-oriented growth to more robust and sustainable engines of activity. The result is much less policy flexibility for central banks, with EMs more reliant on fiscal and structural policies, as well as blunter monetary instruments, such as macroprudential measures, foreign exchange policies and verbal intervention.

If growth stalls or drops, these tools are likely to be much less effective in cushioning the fall, given the procyclicality of fiscal accounts, lower export price elasticity and constrained credit channels in reaction to earlier strong growth in lending. The prospects for these tools if growth rebounds, however, are much more positive; macroprudential measures and currency appreciation are likely to be the first wall of defence, followed by cyclical fiscal tightening arising from higher tax revenues and lower social security-related outlays.

Given our baseline of a modest cyclical upturn in EM with contained inflation, EM central banks are unlikely to be significantly tested on this front and the status quo of relatively stable local yield curves and gradual currency normalisation should continue.

Taking these various factors into account, in our view, investors may want to position portfolios to optimise strategies in EM local markets with positive real rates, steep yield curves and positive output gaps. Such opportunities may include: Brazil, where muted growth prospects are anchoring front-end rates; Mexico, where moderation in the Consumer Price Index underpins the more dovish tone of the monetary policy committee; and South Africa, where structural factors impeding growth are likely to keep rates low for the medium term even if there is a global growth bounce. Meanwhile in currencies, investors may look to take exposures linked to the Chinese and US cyclical rebounds but with adequate protection in a risk-aversion scenario, e.g., the Mexican peso.

Tony Crescenzi, Andrew Bosomworth, Tadashi Kakuchi, Lupin Rahman analyse central banks for Pimco.

© Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved.

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