It has been a remarkable week for central banks and the global economy. It was the week where the bureaucrats controlling the monetary system lost the plot. In Portugal, ECB President Mario Draghi almost promised to make negative interest rates even more negative. In Washington, Federal Reserve Chair Jerome Powell went further out on a limb and introduced rate cuts in the forecast.
It is less than six months ago that Federal Reserve was on auto pilot heading in the opposite direction and ECB was just finishing up its bond-purchase (QE) program in a very slow move towards monetary-policy normalization. Now the two largest central banks have decided that flooding an already flooded financial system with even more cheap liquidity is the way to go.
Equity markets have cheered as the risks associated with the new course are completely ignored. Yields have plummeted in both safe havens and the European periphery. Denmark is close to reaching what a few years ago seemed improbable: all government issuances are close to carrying a negative yield.
Whatever it takes
The party was kicked off at an ECB symposium in Portugal, when ECB President, Mario Draghi, decided to steel the headlines with a bit of news. Under the dull headline of “Twenty Years of the ECB’s monetary policy” Draghi stated that “whatever it takes” still applies: “In the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required.” No buts and ifs. “will be required”.
Draghi highlighted that all tools are in play. ECB has already announced new rounds of liquidity operations (TLTROs) designed to help the weakest banks in the euro area by allowing them to tap the central bank rather than the private market for funding needs. ECB is now looking at lowering the deposit rate, already at -0.4 percent. The bond purchases (APP) could be restarted again.
Draghi even stated that the restrictions imposed on the APP could be eased. Most analysts assume this is directed at the limitations on how much ECB can own of an issuance (currently 33 percent). Lack of available bonds has become a problem in some countries. But a much more explosive restriction is that purchases of government bonds have to reflect the share each country contributes to ECB’s capital (capital key). Doing away with this restriction would cause an uproar in northern European countries.
Draghi’s speech prompted a quick response from President Trump, who accused ECB of trying to manipulate the euro lower. That is not an unjustified accusation, although Draghi reiterated the ECB punchline that Frankfurt does not target the currency.
Bad news are good news
Equity markets rallied on the prospects of more stimulus. However, bank equity lagged behind as the prospects of even more negative interest rates will further diminish margins. Italian banks were the big exception as the change in ECB policy will mostly benefit Italy – the weakest of all euro-area countries. Italian government bonds rallied.
Draghi argued that the need for more stimulus was due to “in particular geopolitical factors, the rising threat of protectionism and vulnerabilities in emerging markets have not dissipated.” He did not mention the Italian government’s willingness to blow up EU’s fiscal rules, which has been an important contributor to uncertainty in the euro area.
It is surreal that the central bank of the euro area believes that buying more Italian government bonds is the solution to a problem created in part by Italy, not least the musings in Rome about introducing short-term debt, which has all the features of a parallel currency. ECB action would eliminate market pressure on the Italian government and thus increases the risk of a more confrontational stance with the EU-Commission.
Furthermore, it is hard to see what more monetary stimulus will do for the European economy. Households in the north are adding to savings as negative returns in the bond market undermines savings for retirement. If banks respond to a lower deposit rate from the ECB by finally introducing negative interest rates for private client, it will cause an uproar in northern Europe. Business do not care about interest rates in making investment decision, when the only argument for the extreme monetary policy is that everything is falling apart. It will do absolutely nothing to increase inflationary pressures.
Moreover, the declining value of European banks tends to depress lending as banks scramble to preserve capital. The value of Italian banks has declined 40-50 percent since the new Italian government took office in May 2018 with the large European banks in the Stoxx 50-index down by between 25 and 50 percent.
Easing from the ECB would end up being symbolic, but also undermine credibility – and will further reduce the effectiveness of measures if the economy should tank. The risk of market turmoil later in the year has risen. More is certainly less in the euro area.
Federal Reserve was not to be outdone by the ECB. Rates were maintained at 2.25-2.50 percent at the meeting in June and the FOMC statement actually kept a fairly optimistic tone in its description of the economy. But Federal Reserve is no longer “patient” in assessing the outlook for growth and inflation but is now “close monitoring” developments.
Unsurprisingly, the monetary-policy statement emphasized the increased uncertainty in the outlook, but there was no explicit reference to a rate cut nor an overweight of downside risks. The outlook for economic growth was maintained between 1.9 and 2.1 percent for the next three years, which is actually not bad considering global headwinds. It is also quite far from a recession.
It was left to the much maligned “dot plot” to send the message on interest rates. The dots, representing the forecast of each individual FOMC member, showed a strong disagreement about how quickly to cut interest rates. An overweight of members still expect the interest rate to stay unchanged this year with at least one cut in 2020. In March, the main scenario was for an interest rate increase next year. However, seven of seventeen members expected two rate cuts this year. The expectation for the long-term was also cut to 2.5 percent, which means that the current economy and monetary policy is viewed as pretty much in a steady state.
Prior to the meeting, financial markets had priced a more than 80 percent probability of a rate cut in July with more cuts later in the year. The initial market response was positive with sharply lower yields and small gains in the equity markets.
Both the monetary-policy statement and the ensuing somewhat awkward press conference reflects that the Federal Reserve is caught between a rock and a hard place.
The increased uncertainty is mostly related to international developments, because much of the US economy is actually doing great, particularly with regards to households. Consumer confidence has rebounded to the highest level since 2001 with a strong assessment of the labor market. While job growth was weak in May, it has averaged 151.000 in the last three months. Unemployment is at the lowest level since the 1960s and household net worth is the highest measured. Debt levels measured against income and GDP continues to decline. Public consumption and investments are also rising.
On the other hand, there has been a clear weakening of corporate confidence, most visible in the manufacturing sector and series of regional confidence indicators. The latest CEO-survey from Business Roundtable was also dour reading. With a waning momentum from the 2017 tax cuts, much points to sluggish corporate investments. Residential construction has been falling quite rapidly.
But on balance, it is the political pressure from President Trump, which has colored monetary policy. With increasingly vocal demands for rate cuts and additional purchases of bonds, Trump has pushed the Federal Reserve into a complete reversal of monetary policy in just six months. Before Christmas, monetary policy was on autopilot towards higher interest rates and a smaller balance sheet. While some adjustment to that course was called for, the new path is not aligned with overall economic conditions in the US. Moreover, trade wars should become more inflationary in coming months as expanded tariffs on Chinese goods take effect. Pulling down inflation is a surge in productivity gains.
President Trump’s demands for rate cuts are closely related to the trade war with China. Trump argues that if the Federal Reserve would easy monetary policy to the same extend as Chinese authorities have ease credit, the US would be in a much stronger negotiating position. However, it is doubtful that lower interest rates would do much to boost US corporate investments. Business tend to value stability in making investment decisions, and the current trade policy is offering the opposite. It is more likely that lower interest rates (and yields) would allow US corporations to continue the current pattern of supporting equity prices through buybacks.
Never disappoint the equity market
The soft tone from FOMC members in recent months have clearly pointed in the direction of easing, and the 2-year government yield has dropped from 3 percent in November to just 1.75 percent now – almost half a percent below the official monetary policy rate. Equity markets are flirting with record highs, and the Federal Reserve always find it difficult to disappoint the equity markets.
Many analysts have argued that the forthcoming cuts to the interest rate could be compared to the preemptive interest rate cut in 1995, when the economy was also doing quite well. However, the situation is much different now. In 1995, inflation had collapsed, in part due to surging productivity. Hence, with a monetary policy rate of 5.5 percent, real interest rates were almost 4 percent and thus quite a severe break on the economy. With the current level of interest rates and inflation, real interest rates are less than one percent and a mere gentle headwind.
Financial markets now expect a rate cut in July to be a done deal, but it will depend on economic data and inflation outcomes. A strong job report for June would make life difficult for Federal Reserve doves. However, the meeting between President Trump and China’s President Xi next week could be decisive. If trade negotiations are resumed, a rate cut can be postponed as downside risks to growth and corporate confidence are reduced. If the standoff continues, equity markets would clearly expect Federal Reserve to react quickly.
No matter what economic outcome, President Trump will be clamoring for more cuts and more aggressive measures to boost economic growth prior to the 2020 election. Musings about firing Jerome Powell, if monetary easing is not aggressive enough, is meant to emphasize the message. Question is how long members of the Federal Reserve can stand the pressure.
Time to locate the lifeboats
Not only the European and American central banks have now reversed course, but monetary easing is also on the agenda in a series of countries. China has gone far in stimulating credit growth and is likely to cut reserve requirements for banks even further. However, total lending has been somewhat disappointing in April and May after a record first quarter. Overall debt is now at the same level in the US and in China. Among developed countries only Norway is moving in the opposite direction.
Actions by central banks imply that the monetary experiment initiated in 2008 now has been extended. Financial markets are addicted to cheap liquidity. Remarkably, central banks – once the pillars of prudence – no longer care about debt levels. More is better. Monetary policy also supports reckless fiscal spending and unfinanced tax cuts. Prioritizing is for losers. But using up your monetary firepower before it is actually needed reduces the ability to counter an actual economic collapse.
It is a gigantic bubble. It might not burst any time soon. But the longer a bubble is inflated, the greater the ensuing bang.