Are central banks losing the plot?

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Central banks are under fire. The Fed seems to be moving away from its long-flagged idea of raising interest rates this year. Meanwhile, the ECB is edging towards stepping up a QE programme that many say is not working in any case. Inflation is below central bank targets in both cases. We think the criticism is harsh. A Fed delay and more ECB QE both look reasonable given the changing environment, with increased downside risks, tighter financial conditions and greater disinflationary pressure. Fed communication could improve though, while the ECB should be quicker and more decisive in policy easing.

The reason for stepping up QE is not that the programme is not working, but rather that the forces weighing on growth and inflation have increased Nick Kounis Nick Kounis Head of Macro Research

‘You don’t know what you’re doing!’

Failing football managers in English football are often jeered by the crowd in the stadium with the chant ‘you don’t know what you’re doing!’ over and over again. Many commentators seem to be having the same reaction to the big central banks right now. Both the Fed and the ECB have come in for criticism and their credibility – crucial for any central bank to operate successfully – has come into question.

Change in course being read as failure

The critique by the cynics goes something like this. The Federal Reserve has lost its nerve. It did not have the courage to raise interest rates at the September FOMC meeting and now seems to be moving away from its long-flagged idea of raising interest rates this year. The FOMC’s communication has been erratic, sometimes putting investors on the wrong foot. Meanwhile, the ECB appears to be moving towards a stepping up and extension of its QE programme. ‘Why step up a programme that has not worked in the first place?’ the critics argue.

When the facts change…

This criticism seems to be harsh. The legendary economist John Maynard Keynes famously asserted ‘when the facts change, I change my mind, what do you do sir?’ And the facts have changed over recent months. The global growth outlook has weakened. Downside risks to China and other emerging markets have come into sharper focus. The stress this caused in markets – which has only really eased since the Fed changed course – led to a tightening of financial conditions. The fall in commodity prices and global manufactured goods prices has intensified disinflationary forces.

The counterfactual

What is sometimes missed in this debate is what would have happened if central banks behaved differently . For instance, if the Fed had gone on to hike in September, would emerging market tensions have severely escalated leading to broader financial stress? Well of course nobody really knows, but was it a risk that was worth taking?

Graph: Central banks missing inflation targets

China and EM sentiment to stabilise over time

If Fed rate hikes will inevitably rattle emerging markets, it could be asked whether delaying rate hikes is a pointless exercise that just kicks the can down the road. There is some truth in this of course. However, hopefully, any Fed delay will buy time for emerging markets to get on to a stronger footing. One necessary condition for this would be signs that China’s growth momentum is becoming less negative, so investors become more confident in a soft landing or gradual slowdown scenario. We think this is likely in the coming months.

Better credit data, property stabilisation

There are already some tentative signs of improvement. For instance, this week, we saw stronger Chinese credit data in September. The broadest aggregate financing measure rose to 1.3 trillion yuan from 1.08 trillion in August. M1 money supply growth also accelerated. This also follows some signs that the property market – a key driver of the weakness in the economy – is stabilising. However, it will take a while before the picture becomes clearer.

US domestic data have also become more cloudy

Another reason for the Fed to wait is uncertainty about the recent momentum in the US economy. Over the last few days, a number of reports have also muddied the US economic growth outlook. Retail sales rose by just 0.1% in September after being flat in August. This follows a number of other weak reports. For instance, nonfarm payrolls slowed in August-September and the ISM manufacturing index reached stagnation levels in September. Most evidence suggests the economy slowed in Q3. Our sense is that this will prove to be a temporary phenomenon as domestic fundamentals are strong. However, the weaker data does create some uncertainty, which may also take time to clear.

The Fed’s communication strategy

Overall then, there seems to be a good case for the Fed to wait and see , especially with inflationary pressures still subdued. Having said that, the message from the FOMC remains rather unclear and its communication strategy could be improved. One of the big communication issues right now is that there are a number of different messages because the Committee is divided.

Splits in the FOMC

This is especially the case with regards to the ten voting members. Three of the ten (Brainard, Tarullo and Evans) have clearly stated they favour a delay to 2016. Meanwhile, the influential President of the New York Fed, William Dudley, has cast doubt on whether the Fed would raise rates this year. On the other hand, three voting members (Lockhart, Lacker and Williams) have stuck with a 2015 view. The Fed’s Vice Chair Stan Fisher has also signalled he was in favour a hike this year, but also stressed that this depended crucially on the assumption that the economy and labour market would remain solid.

Without ECB QE the outlook would be worse

On the other side of the Atlantic, the criticism of the ECB has focused on the effectiveness of its QE programme. The argument is made that the ECB’s QE programme has failed because the inflation outlook has deteriorated. However, this seems to ignore what would have happened without the stimulus.

Euro would be much higher

Take the euro. Before speculation that the central bank would embark on asset purchases built from the Summer of 2014 onwards, the EUR/USD was close to the 1.40 level. Ongoing strength in the euro would have added to the disinflationary pressures, meaning inflation would now be even lower. Similarly, the growth outlook would be weaker. For instance, net exports contributed 0.5% to annual growth in Q2, compared to being neutral to growth at the start of last year.

Graph: Eurozone bank lending rates to companies

Bank lending rates have also fallen

Meanwhile, the ECB’s QE programme has had a depressing effect on core government bond yields and credit spreads. This is reflected in sharp falls in bank lending rates, especially in the periphery. Since the middle of last year, rates on small business loans have fallen by around 80bp in the eurozone, and more than 100bp in the periphery.

Stronger headwinds imply more QE

The reason for stepping up QE is not that the programme is not working, but rather that the forces weighing on growth and inflation have increased. As well as slower global growth, the Fed’s likely delay in raising interest rates has pushed down the dollar and hence strengthened the euro. The ECB needs to do more to counteract this.

Dovish commentary from ECB officials

Indeed, ECB officials stepped up their dovish rhetoric this week. ECB Governing Council member Ewald Nowotny sounded more worried than before about the inflation outlook. He said that the ECB was ‘clearly missing’ its inflation target. This was partly due to oil prices, which the ECB could not control, however he also pointed out that core inflation was also ‘clearly’ below target. He concluded that additional steps are necessary to help the ECB reach its objective.

More decisive action

The ECB indeed looks set to miss its target, yet many officials have said that further easing is premature at this stage. We expect to see an expansion and extension of the ECB’s QE programme in December, but the central could have already acted in September given the inflation outlook in our view.


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