The weakness of global equities and other risk assets in recent weeks has clearly been driven by the deterioration in the eurozone crisis, but that has not been the only factor at work. There has also been concerted weakness in economic activity indicators in all the major economies, while the central banks have been sitting on their hands. That is never a good combination for asset returns.
This week, however, the markets’ hopes have been rising that the major central banks are once again preparing to ease monetary conditions, if not via a formally co-ordinated announcement, then in a series of separate steps which would amount to a powerful monetary boost to the global economy. Although this policy change may take a couple of months to transpire, it does indeed seem to be on the way. The pause in monetary easing which became clear in February/March has once again proved to be only temporary.
As usual, the main actors in this drama are the ECB and the Federal Reserve:
1. The ECB
Today’s meeting of the ECB Governing Council was the first sign of things to come. Although the market was disappointed by the decision to leave policy rates on hold, Mr Draghi’s statement and press conference gave a clear signal that the ECB will take further action if the eurozone financial crisis requires such steps in the next few weeks. Many observers will describe this as “too little, too late”, and the ECB once again is appearing tardy in the face of a sharply deteriorating picture for economic activity throughout the eurozone – not just in the periphery – in the second quarter. Inflation should not be a problem against this backdrop.
It is easy to sympathise with the Governing Council’s view that action on banking recapitalisation and the stabilisation of government bond yields should ideally be left to the ESM and other fiscal agencies, but there do now seem to be more standard reasons for easing monetary policy, notably the downside risks to economic activity which have increased considerably since the ECB’s meetings in April/May. The ECB cannot remain unmoved by this for much longer.
2. The Fed
At some point between the January and March policy meetings, the centre of gravity on the FOMC shifted, at least temporarily, in a more hawkish direction. This occurred because core inflation was proving slightly more sticky than expected. But headline and core inflation have both now subsided, and inflation expectations have dropped close to the levels where the Fed has previously eased policy.
We may learn more about the Fed’s thinking from Chairman Bernanke’s testimony to the Joint Economic Committee of Congress on Thursday. Recent speeches suggest that the FOMC is fairly evenly poised on whether to take more action this month. Bill Dudley, the Chairman of the New York Fed, and normally a good bell weather for the controlling dovish camp on the committee, said last week that there would be a case for additional easing if progress on reducing unemployment were to stall, or downside risks to the economy were to increase. Since then, the employment figures for May, and the deterioration in the eurozone crisis, suggest that both of these criteria may have been met.
However, this is not a done deal for the meeting on 19/20 June. Sandra Pianalto, one of the centrists who normally gives her support to the Chairman, said on Monday that she was not yet convinced that a move in any direction was required. Activity data published so far in the second quarter suggest that the GDP growth rate has remained close to the 1.9 per cent rate recorded in the first quarter. This is unsatisfactory, but not disastrous, considering that the Q2 numbers were depressed by the earlier rise in oil prices, which has now been reversed. With gasoline prices now falling, retail spending is likely to strengthen markedly in the months ahead. And although the growth in employment has clearly weakened in the past 3 months, some of this may be due to the weather and other seasonal distortions.
Another complication which may slow the Fed’s decision making process is that the exact form of any renewed easing will need to be debated at length. A second “Operation Twist” is possible, but its potential scale is limited by the fact that the Fed now has only around $200bn of short dated government bonds remaining on its balance sheet. Meanwhile, a further “conventional” dose of QE, involving purchases of long dated treasuries, may have very little impact on the economy now that the 10 year government bond yield is around 1.5 per cent. This may push the Fed in the direction of purchasing mortgage securities instead of treasuries, possibly sterilising the impact on base money via reverse repos or term deposits.
3. The likely impact
Although these actions from the Fed in June/July would provide a useful boost for US and global activity, it is unlikely that the impact from monetary stimulus will be as great as we have seen in the past. The Fed is not yet thinking of “unconventional” monetary easing, such as buying equities, raising the inflation target, or setting a nominal GDP target. These measures are still in their locker, but are being reserved for a more desperate environment.
The ECB’s immediate menu of options looks to be more impressive. Apart from further LTROs, there is plenty of scope to reduce peripheral government bond yields by reopening the Securities Market Programme, but their willingness to deploy their armoury is still far more circumscribed than the Fed’s. So far, they have been ready to use unconventional policy measures only when the future of the euro, or the liquidity of the banking sector, is genuinely under threat.
Where does this leave us? The recent slowdown in the global economy demonstrates that the world is still heavily dependent on the actions of the central banks to achieve even the mediocre, sub-trend GDP growth rate which has been seen in 2010-12. No matter how hard they try, the central banks have been unable to pass this responsibility on to governments. They will soon be forced to ease again.
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