The world’s central bankers gathered at Jackson Hole over the weekend. What a party that must have been.
The foremost topic of discussion: low interest rates and associated unconventional monetary policy — quantitative easing by any other name. And the consensus among central bankers appeared to be that low interest rates will be with us for a while.
Here are some snippets, from the FT’s report:
Don Kohn, vice-chairman of the Fed, said he saw no contradiction between its commitment to keep rates low for an “extended period” and the desire to keep inflation at moderate levels – though he emphasised that this was a conditional commitment that could change if the economic outlook changed.
Martin Feldstein, a Harvard professor,thought it would be possible to have “two years or more of very low interest rates” without risk of excess inflation, given the spare capacity in the economy.
Rick Mishkin, a former Fed governor, told the Financial Times the Fed would be easing policy further if it were not for the costs associated with monetising government debt.
The interesting thing here, however, is the disconnect between the central bankers’ comments and the market.
At left, for instance, is a table from Bank of America Merrill Lynch’s global economics team, showing that the money market is pricing in some fairly significant rate hikes around the world in 2010.
What’s the deal? Surely either one camp or the other is right here — the central bankers or the market.
Here’s BofA/Merrill economistRiccardo Barbieri with his theory:
At face value, market pricing seems at odds with the current stance of monetary policy around the world and particularly in the advanced economies. Indeed, the Fed and other leading central banks are still engaging in quantitative easing (QE), that is, buying government bonds and asset-backed securities outright. It would be very surprising if they raised rates while they were still buying bonds outright, or if they rapidly reversed course after easing policy to an unusual extent — though the precedent of the Bank of Japan does suggest that securities purchases may well continue while the central bank mops up some of the excess liquidity in a repeat of the Fed’s 1961 ‘operation twist’.
Why, then is the market pricing in rate hikes? We can see two possible explanations: the first is that, particularly during market sell-offs, the bond market, which is under pressure due to also to large supply, ‘pulls’ the short end higher. In other words, the front end sells off ‘in sympathy’ with the long end, though few investors seem to believe that the Fed or the ECB will actually tighten policy in the next six to twelve months.
The second reason has to do with QE. The Fed and the BoE in particular are buying an unprecedented amount of securities and, partly as a result of that, on the liability side of their balance sheet, excess reserves of the banking system have grown sharply. The Fed and the BoE have suggested that as and when credit extension picks up and they decide to mop up some of the excess liquidity, they may do so by raising the rate they pay on bank reserves and/or sell some of the securities in their portfolios. Raising the rate on banks’ excess reserves would in all likelihood entail a rise in interbank rates such as the effective Fed funds.
In other words — should central banks, at some stage, conclude that they’ve injected too much liquidity into the system, and start unwinding some of their unconventional policy measures, they may also have to hike rates in the process. Here’s a bit more detail from Barbieri on that QE point:
The second point requires some additional explanation. We have long argued that the Fed’s securities purchase programs, which if fully implemented would amount to US$1.75tn, would take up most of the asset side of the Fed’s balance sheet — especially if conditions in the money market improve and the liquidity provision facilities decline in size, as has been the case in the past two months. (The Fed’s balance sheet has declined by about 10% since May.)
On its part, the ECB’s approach is based on committing to unlimited long-term funding at a fixed rate of 1%. Indeed, the ECB provided €442bn of financing on the one-year maturity in June, and has announced two additional auctions in September and December. While the ECB said that it may charge a margin over the policy rate, we do not expect the ECB to do so in September, and even December may not be the right time to implicitly signal a prospective rise in policy rates. What this means is that Euro area banks would be able to fund at a 1% rate for the best part of 2010 for unlimited amounts. If the economy surprised to the upside in the coming quarters, the ECB may have to mop some of the liquidity provided to banks through long-term operations by hiking the repo rate and conducting reverse repo operations. In all likelihood, this would entail a rise in interbank rates compared to current levels.
Recapping what we have been arguing thus far, the main reason why the money markets are pricing in significant rate hikes over the next twelve to eighteen months is that with the economic data improving, the market is beginning to think that too much liquidity is being injected into the system and that central banks will have to reverse course quite soon.
So far, so predictable. But we wonder if the disconnect between central banks and the market may be a dangerous thing.
Despite central banks very public prognostications about the need for low interest rates and QE, the market — rightly or wrongly — simply refuses to listen, continuing to price in rather dramatic economic recovery and subsequent inflation.
As economist Nouriel Roubini pointed out in his most recent FT op-ed, if inflationary expectations increase too much, longer-term government bond yields will rise, increasing borrowing rates and could lead to stagflation. On the other hand, if the world’s central banks rush to withdraw their liquidity operations, to match market expectations, they could risk tipping the global economy back into stag-deflation.
Something has to give here.
Related links:
Reflections on a year of crisis – Speech by Ben Bernanke at Jackson Hole
Bank of England extends QE by £50bn – FT Alphaville
Über-QE – FT Alphaville