Unconventional monetary policy: Catch-22

By Didier Saint-Georges, member of the investment committee, Carmignac

Added 20th April 2016

Quantitative easing is far from finished as central banks realise procrastination will not halt deflationary forces.

Unconventional monetary policy: Catch-22

From 2009, the financial crisis led most governments to defer all their economic powers to central banks. The latter have since tried all sorts of innovative policies aimed at easing the financial conditions and encouraging investors to rebalance their portfolios towards risk assets.

Unfortunately, not only has this deluge of financial innovations had little effect on the real economy, it has also generated major iatrogenic – unintended and toxic – side- effects. In many ways, central banks are now captives of their own policies.

Stabilising inflation

That these unconventional monetary policies have so far mostly failed is hard to ignore. Be it in the US, in Japan or in the eurozone, one of the principal objectives was to stabilise inflation rate levels near 2%. This is far from being achieved, as inflation expectations have kept declining and are now anchored well below target levels.

As European Central Bank president Mario Draghi himself admitted, the ECB’s credibility is at stake on this performance measure, justifying, in his view, the pursuit of unconventional policies until the inflation mandate is fulfilled. In the eurozone, February consumer price inflation (CPI) was negative at -0.2%, and the conundrum is similar in Japan and the US.

 In the US, where the latest CPI reading was below 1%, stabilisation of the oil price might flatter year-on-year comparisons for a short while.

But deflationary pressures remain powerful, driven primarily by industrial excess capacity globally and, importantly, by the hysteresis of the 2008 credit crisis, which has led to individuals and companies to favour saving over borrowing.

Janet Yellen referred to this situation when justifying her overall dovish stance on 16 March. The problem here, of course, is that currency manipulations are a zero-sum game. When one country tries to reignite inflation expectations by pushing down its currency, it creates further deflationary pressures in the countries whose currencies appreciate.

Excessive investment

In 2016, this is one of the reasons that will make the US Federal Reserve’s monetary normalisation very challenging; a stronger dollar would penalise the US economy and push down further inflation anticipations.

In Japan, inflation is back down to zero, now that the false hopes elicited by the Abenomics programme in 2013 and 2014 have faded. Since its own great financial crisis of 1990, Japan and its central bank have proved unable to win the battle against deflationary forces, which in Japan’s case are also worsened by an ageing demographic profile.

Interestingly, the situation in China is not dissimilar, as the excessive investment programme launched in 2009 to counter the effects of the financial crisis created the origin of excess global industrial capacity. Chinese producer prices have been in deflation territory for five years, a situation that worsened last year, with producer price index reaching the -5% mark.

Central banks have not only failed to overcome deflationary pressures, they have so far not been able to spur any solid economic recovery anywhere. All the while, there is ample evidence that, based on its current position in the economic cycle, the US could do without any monetary tightening at all. US companies have been in an earnings recession for three quarters already, and consumer confidence has now been on a downward trend for a year. Most recently, retail sales dropped in February, and the prior month’s gain was revised to a decline.

It would be dangerously complacent to see in these softer economic figures only the impact of the recession in the oil sector. The reality is that the US economic cycle has been long and protracted, and is now starting to roll over, as falling corporate margins hurt investments and the waning wealth effects of quantitative easing (QE) are starting to take their toll on consumption.

As it happens, a further monetary tightening by the Fed would not only collide with the needs of the US economy, but it could also trigger additional risks in dollar-hungry emerging countries, with a negative feedback loop on the US economy.

China’s challenge is to deal with its overcapacity without bringing its economy down into recession. It is a tall order. Resorting to a large fiscal stimulus once again to keep the economy going might send the kind of signal that markets love. But by delaying the necessary adjustments now, it would make them even more painful later.

The Chinese economy needs monetary easing to smooth out the impact of industrial capacity destruction on economic growth. Whether that is achievable without putting further downward pressure on the Renminbi remains to be seen, all the more so if the dollar were to strengthen.

Capital controls might prove sufficient to do the trick, but it is far from assured. In case capital outflows would indeed force a depreciation of the Chinese currency, global deflationary pressures would take a boost, forcing central banks to double up on their efforts to reinflate their economies and keep down their own currencies.

As for Japan, the failure of Abenomics and the Bank of Japan’s associated monetary policy to spur economic growth is plain to see, as industrial production has remained totally flat in the past two years. Therefore, there is no question that if unconventional monetary policy is meant to continue until it has reached its inflation and growth targets, it has a long way to go. The other reason why QE is far from finished is that its side-effects are putting the central banks in a bind. First, financial repression has profoundly affected market prices, as central banks’ literal ‘underwriting’ of markets has raised investors ‘acceptance level’ of equities and bonds valuations to sky-high levels.

Should central banks indicate a radical move away from past policy, a brutal reset of asset prices would ensue, with nefarious impact on confidence and wealth effect. In an ironic dichotomy, either the global economy and inflation remain very subdued and justify central banks’ continued activism, or economic growth and inflation ultimately pick up and start pushing interest rates higher, pressing banks to intervene in order to avoid a major correction in bond markets.

Public debt

Second, central banks’ extraordinary actions have bought time so that governments would be able to reform, rebalance their public finances and reduce their debt levels. But none of these has really happened. Public debt levels in the US, Japan, and Europe are higher today than they were before 2008. Such levels would not be sustainable should real rates rise significantly.

Therefore, as long as inflation does not pick up materially, central banks are condemned to maintain their financial repression. It is important here to understand the circular effect of unconventional monetary policies. Pushing down long-term rates on government bonds has not only crowded out investors and encouraged them to take risks, it has had the unintended consequence to make it very tricky for central banks to stop their action.

By making indebtedness more forgiving, they have encouraged governments to delay radical actions to rebalance their budgets, hence a catch-22 situation: low rates have encouraged leverage, which in turn has increased financial fragility and dependence on low rates.

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