As the Fed gets ready to taper ‘QE’, UBS’ Larry Hatheway warns investors to brace for a period of increased international policy tension. Previously harmonized – but not coordinated – monetary policy stances will give way to conflicting objectives and new strains as adverse ‘spillovers’ occur. As Hatheway notes, we are about to rediscover several inconvenient truths. First, the Fed is the US, not the world’s, central bank. Second, international policy coordination is desirable in an interdependent world but, third, it is no more likely to materialize now than in the past. The world, it seems, is destined for a less comfortable policy co-existence in the coming few years.
Via UBS’ Larry Hatheway,
Monetary Policy Tensions?
International policy coordination among major economies (i.e., the US, the Eurozone, the UK and Japan) is rare. In the post-Bretton Woods era of flexible exchange rates, coordination of monetary policy (to say nothing of fiscal policy) is the exception, not the rule.
Yet it is also true that the fortunes of these large economic blocs are interdependent. Trade and capital flows are obvious linkages, but so too are shared risk premiums and real interest rate movements (as we show below). Ideally, given interdependence the optimal policy is a coordinated one designed to maximize welfare across the area of economic integration. Conversely, going it alone can lead to unwelcome outcomes in other economies. These ‘externalities’ can be particularly large when policy shifts in the biggest economies, such as the US, exert a significant impact on smaller economies, developed or emerging.
Until recently, however, there was little reason to fret about the lack of international monetary policy coordination. With the advent of the financial crisis, the world required low interest rates and ample central bank liquidity, which the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan readily furnished in response to the deterioration in economic and financial conditions. To be sure, some policy coordination took place. For example, during the financial crisis the Fed extended swap lines making dollar liquidity available, albeit for a select group of countries.
But, overall, the actions in recent years of the Fed, the ECB, the BoE and the BoJ were adopted to address domestic economic and financial objectives, even if their responses also served the common good by supplying liquidity to meet the sharp increase in global money demand and by providing counter-cyclical policy support for a world economy struggling to recover. Coordination was superfluous because the vast majority of countries, developed and emerging, required the same policy response. National self interest was aligned with the common good.
Now, however, things are changing. The Fed, with an eye on an improving US economy, is preparing to end its super-easy QE policy. But US business and policy cycles are not well synchronized with those of Europe, the UK, Japan or, especially, much of the emerging complex. As a consequence, the Fed is now contemplating a policy shift that, unintentionally, runs the risk of undermining the objectives of other central banks. The stage is set for a rise in international monetary policy tensions.
Where are the pressure points?
The pressure points aren’t hard to see. Rising US bond yields have pushed up long-term interest rates in Europe and the UK. Capital inflows to emerging economies have dried up, precipitating in some cases rapid exchange rate depreciation, which several emerging economy central banks have tried to offset by tightening monetary policy. Problematically, higher interest rates and tighter liquidity conditions have arrived courtesy of shifting Fed policy expectations before recovery has convincingly taken hold (Europe) or as growth has slowed (emerging economies). Typically, some respite might come from a stronger dollar (i.e., domestic currency depreciation), but so far that has not been the case for Europe or the UK, while in some emerging economies currency depreciation has been worryingly rapid, threatening to stoke import-price inflation. Yet these adverse spillovers are also peculiar. Why should European and UK bond yields rise when their economies remain weak, inflation is falling, and their central banks are issuing ‘forward guidance’ as a promise to keep policy rates low for considerably longer? Equally, why shouldn’t a stronger US economy and a less accommodative Fed lift the dollar?
Neither outcome is easy to explain. But one thing is clear – these patterns are hardly unusual. As our global asset allocation team pointed out earlier this year, government bond market correlations between the US and Europe (or the UK) are high (Chart 1), as they have been for the past quarter century. More important, those correlations have been largely invariant to divergences in domestic economic and policy fundamentals. German bund yields, for example, rose alongside Treasury yields in 1994-95 even though the German economy was soggy and the Bundesbank was easing. Back then, Fed tightening and rising US Treasury yields trumped German fundamentals, and there is little reason to believe matters will be different this time.
That does not bode well for the policy steps recently initiated by the ECB and the BoE to offer firm assurances via ‘forward guidance’ that short rates will remain low for much longer. The primary rationale for such pre-commitments is to push down intermediate and long-term interest rates. Yet in an environment of Fed tightening, such measures are likely to be compromised, an outcome which would distress European central bankers if their economies stutter.
The absence of dollar strength is also somewhat of a mystery. Here, several observations are in order. As senior currency strategist Beat Siegenthaler pointed out last week, the euro may be benefitting from a secular improvement in the Eurozone’s trade and current account balances.1 Also the euro has clearly been supported in the past 12 months by Draghi’s commitment to ‘do whatever it takes’ as regards the sovereign crisis. But it is also worth pointing out that exchange rate moves often defy ‘first principles’. In the aforementioned 1994-95 episode, the dollar plunged against the German mark and Japanese yen, despite aggressive Fed tightening alongside the adoption of easier monetary policies abroad. Currency forecasting has always been a perilous task.
A less comfortable co-existence
Summing up, a period of harmonized – but not coordinated – monetary policy responses is coming to an end, with the Fed leading the way out. Unless historic correlations among bond yields break down, the change in Fed policy is likely to have unwelcome consequences for economies lagging the US business cycle, i.e., pretty much the rest of the world. Domestic policy responses to offset the impact of rising US interest rates are likely to be of limited effect. If the dollar doesn’t ‘cooperate’, increased policy tension is the probable outcome.
For many emerging economies, matters are even more challenging. Among the commodity producers, weak growth in China has already taken its toll on export prices, the terms of trade, and currency values. Capital flow reversals precipitated by higher US interest rates are therefore particularly worrisome, lest they unleash sharp currency depreciation, associated inflation pressures and/or result in a drying up of domestic liquidity. And, thus far, the US recovery has not been sufficiently strong to lift emerging economy exports—commodities or manufactured goods—in a meaningful way. Lastly, the stresses associated with Fed tightening are arriving at a time when most emerging economies have reached limits on how much further they can lift growth via domestic credit expansion.
We are about to rediscover several inconvenient truths. First, the Fed is the US, not the world’s, central bank. Second, international policy coordination is desirable in an interdependent world but, third, it is no more likely to materialize now than in the past. The world, it seems, is destined for a less comfortable policy co-existence in the coming few years.