Opening the Floodgates
March 20, 2008
By Joachim Fels | London & David Greenlaw | New York
The Fed enters negative real rate territory. With another sizeable 75bp cut in the policy target at the March 18 FOMC meeting, the Fed has just barely nudged the real fed funds rate into negative territory (using core CPI as an inflation proxy). Thus, the Fed appears to have entered what we called Phase 3 of its easing cycle in last week’s Global Monetary Analyst.
Still, we were somewhat surprised by Tuesday’s action from a number of different standpoints: • First, there were two dissenters who favored a less aggressive move – Plosser and Fisher. Note that this is the first time that there have been two hawkish dissents since May 1998. • Second, although the official statement referenced the weak economy and the fact that “financial markets remain under considerable stress”, the language also included a greater emphasis on inflation risk than the prior version that was released after the January meeting. Indeed, for the first time in memory, the statement indicated that “inflation expectations have risen”. • Finally, in the wake of the unprecedented action announced on Sunday night, we had been looking for a 100bp cut in the funds rate target. We reject the notion that the smaller-than-anticipated rate cut reflects an attempt to save some ammunition. Back in June 2002, the Fed staff produced a widely circulated study of the Japan deflationary experience of the 1990s, which concluded that policymakers should become more aggressive in reducing the target rate as it approaches zero – not less. In fact, as noted in a 2004 paper by Bernanke & Reinhart, “policymakers are well advised to act pre-emptively and aggressively to avoid facing the complications raised by the zero lower bound” (see Conducting Monetary Policy at Very Low Short-Term Interest Rates, January 14, 2004). A compromise between 100 and 50. Instead, the dissents might be a signal that the 75bp outcome represented a compromise between some who pushed for a larger move and those that would go along with only a 50bp cut. It appears that there are at least some members who remain concerned about inflation risk and perhaps some who have related concerns regarding the dollar. In any case, it’s worth noting that the move involving Bear Stearns that was announced last Friday morning, as well as the broader actions unveiled on Sunday evening, related to the discount window. The votes authorizing these actions were unanimous. However, the discount window policy is under the control of the Board of Governors, so none of the regional bank presidents had a vote. And, with the Board down to only five members (due to a couple of unfilled vacancies), the regional bank presidents account for a larger proportion of the voting members of the FOMC than is typical. This might have been a restraining factor in the outcome of the March meeting. Rate cut complements new lending facility. The new Primary Dealer Credit Facility (PDCF) that was unveiled on Sunday night and yesterday’s rate cut should be seen as complementary measures. The PDCF essentially opens the discount window to primary dealers in amounts only limited by their holdings of eligible collateral (at a rate that is 25bp above the fed funds target). The allowable collateral is narrower than the discount window but still very broad – the normal open market collateral of Treasuries, agencies and agency MBS plus investment grade corporates, munis, private-label MBS and other asset-backed securities. And while the loans will be overnight, they can be rolled over for at least six months. Our financing desk believes that the new facility represents an important positive step for the financial markets, since it could serve as the backstop for primary dealer financing of a wide range of assets, and this should lead to reduced counterparty concerns and improved liquidity. Out of basis points? Maybe, but not out of bullets. Although the fed funds target is now down to 2.25%, we believe that it would simply be a mistake to argue that the Fed is running out of bullets. While the funds rate target is approaching zero and the special facilities that have been introduced in recent months absorb much of the central bank’s balance sheet, the Fed can always remove the sterilization constraint that has been in place to this point and shift to so-called quantitative easing (QE). In fact, the Fed is the lender of last resort and, as such, has almost unlimited ability to monetize the debt of the US economy (and foreign economies for that matter!). The Open Market Desk already has the statutory authority to purchase Treasuries, agencies, agency MBS and obligations of foreign governments – and the ability to pay for these purchases by creating money. Moreover, the Fed can provide financing for a limitless volume of private debt via repurchase agreements. Quantitative easing bears risks, but… Of course, such moves aren’t to be taken lightly. The historical lessons suggest that these sorts of episodes can end very badly – see, for example, the hyperinflation experience of Germany in the 1920s, Latin America in the 1980s and Zimbabwe in recent years. However, inaction might represent an even more dangerous option if the situation continues to deteriorate. In the end, while we certainly don’t view QE as the most likely outcome, there should be no mistaking the fact that the Fed retains this option. Inching closer to the great global monetary easing. In response to the rising strains in the financial system, further dollar weakness and the large Fed rate cut, other central banks are now more likely to ease (or tighten by less) too: • Our euro area economists have just cut their growth forecast for the next several quarters and now expect the ECB to cut rates by 25bp later this year and once again at the beginning of next year. • In Japan, our BoJ watcher Takehiro Sato now feels even more confident in his out-of-consensus call for a 25bp rate cut in the April-June quarter, once the BoJ leadership issue is resolved. • In the UK, our team has upped its subjective probability of the next cut coming at the April 10 meeting from 45% to 55%. • In Canada, where we currently expect a 25bp cut at the April 22 meeting, chances of a larger 50bp cut have increased dramatically. • In Australia, it has become less likely that the RBA will hike once more. • In China, while the authorities yesterday raised reserve requirements yet again, our economists continue to think that further interest rate increases are unlikely in an environment where the Fed is slashing rates. Thus, central banks around the globe are moving closer to what we called ‘The Great Monetary Easing of 2008’ in early January. On intervention watch. Apart from more interest rate action, the case for co-ordinated FX intervention to support the dollar has become more compelling with the recent slide in the dollar. Our currency economist Stephen Jen assigns a subjective probability of 40% to such action at this point, with the risk of intervention rising by the day. Liquidity cycle turning. Taken together, the Fed’s and other central banks’ recent and prospective action will, in our view, eventually pave the way for a recovery of asset markets and the global economy in 2009. For now, we are still stuck in the bottom left quadrant of the global growth/liquidity cycle (see page 4 of the Global Monetary Analyst, March 19, 2008), defined by a weak economy and poor liquidity. In this quadrant, equities and credit are in a bear market, while government bonds and other safe havens such as gold and the Swiss franc are in high demand. However, while the economy is still deteriorating and we are hence still moving left along the growth axis, global monetary easing implies that liquidity is starting to improve and we are hence moving north along the liquidity axis. The beginning of the end. In fact, following this weekend’s rescue operation, our credit strategists both in the US and Europe have become more constructive on credit markets following last weekend’s events. While they point out that bear markets don’t turn on a dime and the troughing process may take weeks or even months, they now think that we are seeing the beginning of the end of the bear market in credit.
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Currency Interventions and Relative Monetary Policy
March 20, 2008
By Stephen Jen & Charles St-Arnaud | London
Summary and Conclusions Theory suggests that, for currency interventions to be effective, they need to be (1) unsterilised, (2) consistent with the absolute trend of monetary policy of the country in question, and (3) consistent with the relative trends of monetary policies between countries. Examining the past joint interventions, we point out that historical facts don’t support (1) or (2), but they do support (3). Therefore, for the current environment, the fact that the Fed is easing does not prevent it from conducting currency interventions. However, it is important for the monetary paths of the Fed and the ECB to cease diverging. Monetary convergence does not need to be a precondition, but if the G7 conducts joint interventions, they will need to be followed by interest rate convergence. Interventions and Monetary Policies: What Theory Says Orthodox economic theory suggests that, for currency interventions to be effective, three features about monetary policy must be satisfied. First, such currency interventions must be unsterilised, i.e., the monetary authorities do not offset, through open market operations, the buying and selling of currencies. In other words, high-powered money should be allowed to augment the official operations in the currency markets for the latter to be effective. Second, currency interventions need to be consistent with the monetary policy of the country whose currency is the target of interventions. Specifically, the argument is that, as long as the Fed is on an easing path, it will be difficult for the US Treasury to intervene to support the dollar. Third, interventions need to be broadly consistent with the relative monetary paths between countries. For the ECB to participate in such a hypothetical joint effort to push up the dollar and push down the EUR, it will need to alter its monetary path, and there needs to be a reasonable expectation that the ECB will ease following an intervention. What History Says History is quite unsupportive of the aforementioned economic theories, with the exception of (3), that the relative monetary paths should stop diverging for joint interventions to be successful. Regarding sterilisation, all the currency interventions conducted by the US have been sterilised; there were no exceptions. Full sterilisation is a necessary outcome of the Fed’s independence. By and large, these currency interventions in the past two decades have been quite effective in altering the paths of the USD, JPY and EUR, quite contrary to what theory says and what academics are arguing now. The only cases of partially sterilised interventions were the unilateral interventions conducted by Japan’s Ministry of Finance in the years prior to 2004. But even in those cases, the BoJ permitted base money to rise, consistent with the reserve money targets under the Quantitative Easing (QE) regime. In short, in a world of central bank independence, the debate on the sterilisation of currency interventions is academic, and history suggests that such a debate may not be that relevant anyway, as joint interventions have been quite effective even with sterilisation. History is equally unkind to the widely held view that monetary policy of the key central bank needs to be ‘in sync’ with currency interventions, as consistent monetary – in absolute terms – and currency intervention objectives were more of an exception than a rule. However, relative monetary paths have shown quite a strong and consistent relationship in the past 20 years with the intervention objectives. Monetary policies have shown little consistency with joint currency interventions in absolute terms, but much consistency in relative terms. We looked in greater detail at each of the five episodes of joint interventions: (1) Plaza Accord of 1985 to devalue the dollar; (2) Louvre Accord of 1987 to halt the slide in the dollar; (3) G2 intervention to support USD/JPY in 1995; (4) G2 intervention to slow down the rise in USD/JPY; and (5) G7 intervention to support the EUR in 2000. For each of these episodes, we first examine whether the central bank of the key currency in question had a policy that was consistent with the objective of the interventions. We then ask the question whether the intervention objective was consistent with the relative monetary paths, multilaterally in episodes 1, 2 and 5, and bilaterally in episodes 3 and 4. We make the following observations: 1. No strong relationship between the ‘absolute’ monetary stance and the intervention objective. In most of these five episodes of interventions, the country of the currency in question did most of the ‘heavy lifting’ in the interventions. It is thus important to ask if the central bank of the ‘key’ country had a monetary stance that was consistent with the intervention objective, i.e., was the central bank easing when the objective was to weaken the currency, and was it tightening when it tried to strengthen its currency? We find that, in two of the cases, the ‘absolute’ monetary stance was consistent with the currency objective (Plaza in 1985 and Louvre in 1987), and was somewhat consistent in the case of USD/JPY intervention in 1995. The ‘absolute’ monetary stance was inconsistent in the 1998 USD/JPY intervention and the EUR intervention of 2000: the BoJ was cutting rates when the G2 tried to cap USD/JPY, and the ECB embarked on an easing campaign soon after the 2000 intervention. 2. A solid relationship between the relative monetary stance and the intervention objective. Since exchange rates are relative prices, we also examined how the relative monetary policy stance evolved around the time of the intervention. We find that the Plaza Accord of 1985 was the only episode in which the monetary policies trended tightly among the G5 and were not particularly supportive of the aim of weakening the dollar. In the case of the Louvre Accord in 1987, the interest rate divergence was stark and theoretically very supportive of what the G6 were trying to do. In the other three episodes (USD/JPY interventions of 1995 and 1998 and the EUR intervention), while all interest rate paths were heading in broadly the same direction, the currency that was to be ‘devalued’ had the most dovish path, in relative terms, and the currency that was to be ‘revalued’ had the most hawkish path, in relative terms. A Measure of the Success of Joint Interventions Eye-balling long-term exchange rate charts, one needs little convincing that all five episodes of coordinated interventions were successful in significantly altering the paths of exchange rates. However, instant satisfaction or instant success from interventions was not the rule. When looking at the time lags before the intended results materialised, Plaza generated ‘instant satisfaction’, partly because the dollar had already begun to decline before the Accord was agreed. The Louvre Accord and the EUR intervention did not immediately turn the currency paths around, but did eventually mark the turning points for the USD and the EUR, respectively. In short, while the lags were long and variable, G7 joint interventions have had a close to perfect record, in retrospect. The Chances of Success of This Prospective Operation The current situation is unlike any of the previous episodes of coordinated interventions. From the currency perspective, the prospective coordinated intervention would be to support the dollar, much like the Louvre Accord in 1987. But from the interest rate perspective, the current situation is more like the 2000 episode, whereby the Fed led the world in a global easing cycle, except that the lag between the Fed and the other central banks may be significantly longer this time around. It is even possible that the rest of the world will not have time to ease before the Fed itself starts to hike rates again, in early 2009. In any case, the interest rate paths are unlikely to enhance the chances of success of this prospective joint intervention, but extreme under-valuation of the dollar, especially against the European currencies, will be supportive of such a prospective effort. Divergence in monetary policy remains the biggest hurdle for joint interventions. Bottom Line G7 joint currency interventions since 1985 have had a near-perfect record. Not all intervention efforts led to immediate U-turns in currencies; however, from a long-term perspective, all five major joint interventions since 1985 did indeed mark the multi-year turning points. Examining the relationship between monetary policy and these interventions, we find that there was weak support for the view that full sterilisation undermined the effectiveness of interventions, or that the monetary policy of the country in question needed to be ‘in sync’ with the intervention objective. We did find strong support, however, for the notion that the relative monetary policies between countries needed to be in sync with the intervention objective. The takeaway from the current situation is that the Fed-ECB monetary path will need to stop diverging for joint interventions to be successful.
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