2/22/2014

A dose of humility from the central banks | Gavyn Davies

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A dose of humility from the central banks

February 13, 2014 6:00 am by Gavyn Davies

The leading central banks in the developed economies have, of course, been the main actors underpinning the global bull market in risk
assets since 2009. For long periods their stance has been unequivocally dovish as they have deliberately tried to strengthen an anaemic
global economic recovery by boosting asset prices.
In the past week, we have had major statements of intent from Janet Yellen, the new US Federal Reserve chairwoman; from the
European Central Bank; and from the Bank of England. After multiple hours of fuzzy guidance about forward guidance, the clarity of
previous years about the global policy stance has become much more murky. Central banks are no longer as obviously friendly to risk
assets as they once were but they have not become outright enemies, and they are unlikely to do so while they are concerned that
price and wage inflation will remain too low for a protracted period.
It is now quite difficult to generalise about what central bankers think. However, a few of the necessary pieces of the jigsaw puzzle
slotted into place in the past week.
The Federal Reserve
The first point to make about Ms Yellen is that she has declared herself to be the agent of continuity not the harbinger of a significant
regime shift at the Fed. Most observers (Tim Duy, for example) would say that this was always obvious but we should not allow the
arrival of a new Fed chief to pass without noting that Ms Yellen does not see herself as a game-changer like a Paul Volcker or a William
McChesney Martin.
They both took dramatic action to control inflation. In a similar vein, many members of Ms Yellens intellectual grouping at Berkeley
Christina and David Romer and Brad DeLong are prominent examples wanted her to declare a regime shift designed to shock the US
economy back towards the pre-2008 trend line. That would have involved targeting a recovery in gross domestic product of 10 per
cent or more from present levels.
Why has she not done this? One compelling reason is that the members of the Federal Open Market Committee would not have
supported her in sufficient numbers, and she wants to be seen as a committee person. Another reason is that President Barack
Obama does not come from the same economic mould as FDR, so the fiscal part of such a regime shift is not on the agenda. A final
reason is that she does not seem convinced that a further large dose of asset purchases would be successful anyway, in the context of a
large drop in both productivity growth and the labour participation rate.
Economists at the Fed, like the Congressional Budget Office, have been moving towards supply-side pessimism, implying that more of
the post-2008 output losses are now thought to be permanent. Ms Yellen said on Tuesday that she was not sure how much of the
decline in the labour participation rate could be reversed. Her uncertainty about this scarcely supports dramatic policy action either
way.
There are also signs of supply-side pessimism at other central banks.
The Bank of England
The BoEs latest Inflation Report has reduced productivity growth projections, and says that the amount of spare capacity in the
economy is only 1-1.5 per cent of GDP, despite the fact that the level of GDP is still below the 2008 peak. To the extent that its latest
phase of forward guidance is decipherable, the BoE seems to be eager to reassure markets that the bank rate will rise very gradually,
and to a low end point, but it does not fully eliminate the possibility that the first UK interest rate rise will come this year.
The European Central Bank
The ECB also has a pessimistic view of the supply side, which explains why it does not see any urgent need for a big monetary policy
change as inflation drops towards zero. That does not mean it will refuse to cut interest rates into negative territory next month. My
interpretation of the supposedly neutral steer from Mario Draghis press conference on Thursday last week is that the ECB president
said only that more information would be needed before action would be taken. That information would come in the form of the ECBs
inflation forecast for 2016, which would be published earlier than usual.
A sensible guess at that forecast can be made, given that it will depend on market forward rates for oil prices, which are falling.
http://blogs.ft.com/gavyndavies/2014/02/13/a-dose-of-humility-from-the-central-banks/

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2/22/2014

A dose of humility from the central banks | Gavyn Davies

JPMorgan reckons the likely forecast for eurozone inflation in 2016 will be 1.5 per cent, compared with 1.2 per cent in 2015. That
seems to offer Mr Draghi enough evidence of a prolonged period of exceptionally low inflation, which is what he needs to get the
German Bundesbank to support action. But it does not point to a threat of outright deflation, without which ECB balance sheet
expansion looks improbable. Mr Draghi went out of his way to differentiate between these two different states of the economy last
week.
Conclusion
If the central banks are becoming more pessimistic about the supply side, this could spell danger for markets that have perhaps already
priced in a strong medium-term recovery in GDP towards previous trends. Without the prospect of this GDP recovery, the high share
of profits in current GDP could start to pose problems, especially if the central banks are expected to raise short rates within a year or
two. Regardless of the path for short rates, asset purchases are petering out everywhere except in Japan, and Chinese liquidity
withdrawal is adversely affecting Asian monetary conditions.
Yet the prospect of genuinely hostile central banks for markets still seems some way off. Above all else, policy committees seem highly
uncertain about the right path for interest rates now that asset purchases are ending. But there is an emerging degree of consensus that
global inflation, notably wage inflation, remains inconsistent with their mandates.
The Romers wrote: Central bankers should have a balance of humility and hubris. At present, they seem to be leaning towards
humility about what they know and can achieve. In an environment of unavoidable doubts about the labour market constraints that
they are facing, it seems that they will let wage inflation increasingly act as the judge and jury for the stance of policy. Their latest
refrain is that inflation will return to target, but only over a prolonged period, and that wage inflation will be the crucial signal.
Only when wage inflation starts to rise should markets really start to worry.
Tags: Bank of England, ECB, Emerging markets, Inflation, Janet Yellen, jobs, Mario Draghi, quantitative easing, tapering
Posted in Central Banks, Federal Reserve, Global economy, Monetary policy | Permalink

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