Turning back the Clock on Global Monetary Policy

Sovereign risk and debt continues to mark the fault lines in the global macro landscape and thus the main discourse. In this context and although the technical recovery is still a reality the discourse has started to move into a decidedly bearish mood. I find this interesting since while financial markets, in traditional fashion, have reacted strongly and early on the sovereign debt crisis in Europe it is only now that we are about to close the book on H01-2010 that we are seeing significant and lingering worries from all sides that the we are headed straight into a double-dip recession.

To put it differently. My call, a week ago, concerning short term belief in a technical recovery may now return to haunt me. Of course, in that specific note I did talk about divergence and I think this is really important to factor in when talking about the global economy. Consequently, and even in the context of developed economies alone there will sharp divergence between economies that will return to some form of growth and others who will linger in depression. Conversely, in relation to the emerging economy edifice I am largely constructive and indeed, the problem here is how to deal with the volume and volatility of yield chasing inflows as a result of super abundant liquidity provided by the G3 central banks. As I keep on emphasizing the idea of a global monetary transmission mechanism (and subsequent carry trades) and how they interact with domestic monetary policy decisions and objectives is very important to factor in to your analysis.

In that respect, Morgan Stanley’s Manoj Pradhan had a very good birds eye view of global monetary policy last week and specifically, the following point is a good way to conceptualize some of the costs and challenges associated with being the first to raise interest rates while G3 liquidity is provided in ample quantities.

Thanks to the Great Recession and the synchronised policy response to it, central banks find themselves riding in a monetary peloton. Central banks like the Bank of Israel, the Norges Bank and the RBA that started hiking rates early (the front-riders) faced dual headwinds. First, the widening interest rate differential and abundant liquidity drove their currencies’ values higher. Second, higher policy rates failed to translate into tighter financial conditions due to low bond yields and buoyant equity markets in the major economies to which most financial markets around the world remain linked.

This is very close to my own viewing of the current setup in the global economy and also a setup which links in with the discourse on global imbalances. Concretely, you only need to add Pradhan’s first and second point above to see how it may effectively make higher interest rates counter productive relative to the aim of cooling domestic overheating and bubbles in the making. In fact, by raising interest rates while the G3 are in QE may lead to an exacerbation of the very boom in domestic inflation/assets that the tightening bias was meant to secure against in the first place.

Apart from chapter 4 of the recently published Global Financial Stability Report by the IMF (which is really a must read), a new paper from the Asian Development Bank also discusses this issue with specific focus on Asia and the distinction between floaters and non-floaters relative to the USD.

Turning to the immediate economic cycle Pradhan notes the fact that hitherto hawkish central banks (e.g. Israel, Norway, and Korea) have recently backtracked on their interest rate increasing credentials.

Just a few months ago, most central banks were likely deciding how soon they would have to begin their hiking process. It was too early then for most G10 central banks to start raising rates (with the notable exceptions of Norges Bank and the RBA) but markets mostly saw risks that would tempt monetary policymakers to hike sooner rather than later. That was then. Now, the risk of a spillover of euro area problems into global growth and commodity prices and a subsequent dampening of inflation expectations have shifted risks the other way. Our US and euro area teams have pushed back the first rate hikes from the Fed and the ECB to 1Q11 and 3Q11, respectively. In addition, the ECB’s asset purchase programme (and, to a much lesser extent, the reinitiating of FX swap lines between the Fed and major central banks) has been a step in a direction directly opposite to an exit from QE. In other G10 economies too, central bank statements show increasing concerns about global growth and funding market stress.

In its recent monetary policy report, Norway’s central bank played down the expected increase in interest rates (although I expect them to resume hiking in due course), the central bank of Korea also opted to leave interest rates on hold and so did the Bank of Israel. More importantly and contrary to earlier expectations the first half of 2010 has not seen the reduction of QE wielding central banks, but actually added one to the fold in the form of the ECB biting the bullet and engaging in outright purchases of Eurozone government paper. And thus as Mr. Pradhan points out, the day when excess liquidity is going to be mopped up has been postponed yet again. If, as I expect, the Reserve Bank of Australia also opts to shelve an otherwise planned (or earlier expected) interest rate hike this Tuesday, a clear picture of monetary backpedaling is emerging.

Bugs in the System …

To be perfectly honest, Martin Wolf does not really put anything new to the table in his latest column which paints the global economic system as one being populated by grasshoppers (the importers/deficit nations) and ants (the exporters/surplus nations). Still, his allegory is interesting and useful in terms of pinpointing the current setup of the global economy characterised, as it were, by macroeconomic imbalances and no real way to resolve them since there are simply too many would-be ants and not enough grasshoppers. But wait a  minute, this my spin on the story not quite, I think, how Mr. Wolf sees it;

Today, the ants are Germans, Chinese and Japanese, while the grasshoppers are American, British, Greek, Irish and Spanish. Ants produce enticing goods grasshoppers want to buy. The latter ask whether the former want something in return. “No,” reply the ants. “You do not have anything we want, except, maybe, a spot by the sea. We will lend you the money. That way, you enjoy our goods and we accumulate stores.”

(…)

What is the moral of this fable? If you want to accumulate enduring wealth, do not lend to grasshoppers.

Now, let me reciprocate Martin Wolf in his analysis by also bringing nothing new to the table in my continuing emphasis on demographics and specifically how demographics ultimately determine whether you turn up being an ant or a grasshopper or perhaps even how and why you merge from the latter into the former. My small niggle with Mr. Wolf’s argument is thus the implicit assumption, as I see it, that you can actually choose to be either an ant or a grasshopper. Naturally, to some extent you can, but I would qualify the argument in a very important way. In this way, demographics and specifically an economy’s median age is a good yardstick through which to determine whether it will act more as an ant or a grasshopper. In a nutshell, as the median age increase you become more and more like an ant with the subsequent desire and need to accumulate liabilities on others in order to achieve economic growth and preserve wealth. And this brings us to Wolf’s final point and the alleged moral which I believe is false, indeed almost non sequitur. In this way, we need the grasshoppers just as well as we need the ants and specifically if ageing (which is a convergent global phenomenon), as I argue, leads to an increasing prevalence of ant like behavior the scare resource becomes the grasshopper who are willing and able to borrow.

Small business, big effect

One of the great unsung stories of this “crisis” (at least seen from my perch) has been conditions for small business and especially credit and lending conditions. This is odd since in terms of the real economy these companies are far more important than their bigger listed brethrens; or at least as important. Consequently and while the post March-09 rally has seen many a big listed company head back to the trough in the form of issuing stock or debt (as well as the odd IPO and M&A) the conditions for small business has in many respects remained lackluster. Or have then? Well, I have not done the analysis myself and any analysis on this subject is bound to be very sensitive not only to the country in question, but indeed also the region/state and industry.

This makes it inherently difficult to generalize but I still found this report by the Atlanta Fed about the credit conditions for small businesses in Alabama, Florida, Georgia, Louisiana, Mississippi and Tennessee (using a survey sample of 311 companies) an interesting read. What I especially like was really the introduction in which Paula Tkac (assistant vice president and senior economist at the Atlanta Fed) touches on the very important issue of disentangling supply and demand drivers in the context of assessing the impact of “tighter” credit conditions. In this sense, deleveraging which has now become one of the main underlying structural forces that drive real economic activity essentially may be propelled by both demand and supply factors.

On the demand side, simple changes in preference may lead to a lower demand for debt or more precisely, the correct discounting, by the individual or the company, of her economic situation may lead to less demand for debt. In addition (and very relevant for the analysis by the Atlanta Fed) demand may go down because some would-be borrowers are “discouraged” from applying for credit as they anticipate a negative outcome of their application. On the supply side and beyond the obvious effect of raising price/the interest rate (in a wide discretionary move) credit may simply not be available in the same quantities or some economic agents may be precluded entirely from having access to credit.

As Paula Tkac notes, it is difficult to say when one ends and the other begins and ultimately, supply and demand effects will be interrelated. The concrete results from the Atlanta Fed survey, while note general, suggest that the traditional discourse of blaming conservative or frightened banks (or perhaps even capital requirements and thus regulation) is essentially a pot shot;

Indeed, the results of our April 2010 survey suggest that demand-side factors may be the driving force behind lower levels of small business credit. To be sure, when asked about the recent obstacles to accessing credit, some firms (34 firms, or 11 percent of our sample) cited banks’ unwillingness to lend, but many more firms cited factors that may reflect low credit quality on the part of prospective borrowers. For example, 32 percent of firms cited a decline in sales over the past two years as an obstacle, 19 percent cited a high level of outstanding business or personal debt, 10 percent cited a less than stellar credit score, and 112 firms (32 percent) report no recent obstacles to credit. Perhaps not surprisingly, outside of the troubled construction and real estate industries, close to half the firms polled (46 percent) do not believe there are any obstacles while only 9 percent report unwillingness on the part of banks.

In many ways, the idea that demand side factors are just as prevalent in the process of deleveraging as are supply side conditions is an important entry point to understand the real economic dynamics from the crisis on, in this case, the US economy. In this sense and if you will allow me to briefly expand the perspective it means that there is no switch that can be turned on which will bring us back to normal once funding conditions in the bank sector returns to normal. Indeed, during the initial phases of the crisis in which the seizure of the wholesale money market was the talk of the town a widespread assumption emerged, almost by definition, that once central banks had restored confidence the supply of credit/funding could return to normal and we could be back on our merry way. We know now of course that this was not the case and while the huge back draft of turd assets and the concrete need to rebuild balance sheets still acts as an important supply side constraint I take the Atlanta Fed’s analysis as a small and local evidence for the notion that a more profound structural change has taken place.

Well, I may be taken it too far of course and I certainly would not want to make the Altig et al. at the Atlanta Fed straw men for my musings, but I still hold this to be significant. The report by Paula Tkac is worth reading in its entirety as it also goes into the obvious point that the impact on small business credit conditions from the crisis is strongly industry biased (basically, construction and real estate companies face much tougher credit conditions).