The Bank for International Settlements warned about the dangers of easy monetary policy, saying there is a disconnect between upbeat financial markets and developments in the real economy, as well as about financial imbalances more generally. It also emphasised the risk of normalising monetary policy too late and too gradually.
Financial risks could well become a problem again some point down the line, but that does not look like an immediate concern.
Nick Kounis Head of Macro Research
The IMF and most major central banks have taken a different view. We do not see evidence of significant and widespread asset price misalignments in major economies, while credit growth generally remains weak. Financial risks could well become a problem again some point down the line, but that does not look like an immediate concern. Meanwhile, for the UK and the US, the start of monetary policy normalisation is edging closer on the basis of traditional targets such as inflation and unemployment. This is in contrast to the eurozone.
BIS warns about market euphoria and financial imbalances…
The week started off with the annual report of the Bank of International Settlements (BIS). The so-called central bank of central banks warned about the challenges ahead for economic policy makers and the world economy. Its over-arching point is that policymakers are relying too much on easy monetary policy and too little on structural reform to revive growth, which has led to dangers. Pointing at the strong rise in advanced economy asset prices and decline in volatility, it argues that there is 'a puzzling disconnect between the markets' buoyancy and underlying economic developments globally'. It also went on to express concern about the risks of financial imbalances, some of which had not been completely resolved since the crisis, with debt to income ratios remaining high in many cases. In emerging markets, it asserted that some countries less affected by the global financial crisis were in the late stages of financial booms. China was a particular concern.
…and the risk of normalising monetary policy too late
Against this background the BIS judged that the risk of normalising monetary policy too late and too gradually should not be underestimated. It also seemed to play down risks of deflation. The IMF and most major central banks have taken a different view. They have been mainly focused on meeting traditional monetary policy goals such as unemployment and inflation. In addition, the general view is that macro prudential tools should be used where financial stability risks emerge. For instance, the BoE recently announce measures to try to restrain riskier mortgage loans given the strength of the housing market.
Little evidence of widespread asset price misalignments…
We do not see evidence of significant and widespread asset price misalignments in major economies. Admittedly the recovery in the global economy has been lacklustre up until recently but the corporate sector has looked strong, with balance sheets looking healthy, default rates low, and – in the US – profit ratios at historically high levels. In addition, financial markets are forward looking and there are increasing signs that global economic growth is set to accelerate significantly to above-trend rates. Equity valuations are below historical averages in the eurozone and particularly in emerging markets, while in the US they are above averages but not by a striking amount. Credit spreads are low, but this seems to match up with good fundamentals and limited supply. The evidence of new housing market bubbles around the world is also patchy. For instance, the housing market looks over-valued from a historical perspective in the UK, but this is not true for the US or Germany, where the opposite is true.
…or credit bubbles, while balance sheets look healthy
At the same time, credit growth remains subdued in most advanced economies. So the situation currently looks different from the credit fuelled-asset price booms that we saw for instance in the run-up to typical financial crises. Furthermore, although credit ratios do indeed still look elevated from a historical perspective in some countries, assets are even higher compared to history. US and European companies and households have net financial assets that are well-above long term averages relative to their economies. Of course high debt ratios in themselves cannot be ignored because they make the private sector more sensitive to higher interest rates. However, they are also one reason to think that central bank policy rates can peak at somewhat lower levels than in the past. Finally, debt in some emerging markets looks elevated and is a risk to the global economy that has been frequently mentioned in these pages. China’s debt in particular is at levels that would usually set off alarm bells. However, debt is in domestic currency and the authorities have the levers and fire power to help to ensure a gradual deleveraging. Furthermore, part of the authorities’ reform agenda is aims to achieve an orderly deleveraging.
Financial risks could build in the future
The BIS provides detailed analysis on the financial cycle and were one of the few bodies that seriously warned for imbalances in the run-up to the global financial crisis. So their warnings should not be completely dismissed. Given the combination of easy monetary policy and recovering economies, financial imbalances could well build in the coming years. Policymakers need to monitor these risks carefully. However, targeted macro prudential policies to cool particular segments look like a good way to start, as it is difficult to meet multiple targets (unemployment, inflation, financial stability)
with just the interest rate tool. On the other hand, we fully agree with the BIS that governments should step up structural reforms. Trend growth looks to be slowing, for instance due to ageing, and the only source of long term prosperity is improving the supply side of economies.
Some central banks are edging toward policy normalisation on macro grounds
Away from the pure financial stability issues, some central banks are edging towards the beginning of policy normalisation on the basis of their traditional goals such as inflation and unemployment. The BoE has signalled that it may raise interest rates by the end of this year as economic growth is above trend and unemployment is falling rapidly. The Federal Reserve will likely wait longer, but recent upbeat labour market data (see below) suggest that it will start to raise interest rates during the course of next year. Other central banks – such as the ECB – will likely keep interest rates on hold for even longer (again see below).
US jobs surge, unemployment drops further
Last week’s US labour market data were strong. Nonfarm payrolls rose by 288K in June, which was far above the consensus forecast of 215K. There were also upward revisions of 29K to previous months. This meant that the average monthly gain in Q2 was 272K compared to 190K in Q1 and 198K in Q4. So there is little doubt that job growth has stepped up a gear over recent months. Meanwhile, the unemployment rate also painted an upbeat picture, falling to 6.1% from 6.3% in May, while expectations were for no change. The unemployment rate in June was already touching the FOMC’s projection for Q4 of this year (at 6-6.1%) published last month. As such, the pattern of unemployment surprising the Committee on the downside has continued.
If the unemployment rate continues to fall at the same pace in the second half of the year as it has done in the first, the unemployment rate would reach the Fed’s end 2015 forecast (around 5.5%) already by the end of this year. A key assumption behind the idea that the pace of unemployment declines will slow, is that labour force growth will pick up as discouraged workers start looking for work. In addition, people who are currently working part time, could start to work more hours. There are certainly question marks about the extent to which this will happen and, on balance, we judge that the unemployment rate will continue to fall relatively quickly. This should set the scene for earlier Fed rate hikes than markets are pricing in. Indeed, following the report, markets adjusted up their short expectations and this supported the dollar. However, the adjustment has further room to go. We think US policy rates will go up by mid-2015.
ECB President Draghi strikes relatively neutral tone
Finally, after the fireworks of the June ECB meeting, July’s edition was a relatively grey affair. The main information came in the details of the TLTROs (see below). The communication was relatively balanced. Mr Draghi noted that the June package of measures had eased financial conditions and expressed confidence that the TLTRO would help get inflation back to the ECB’s price stability goal. On the other hand, he repeated that the ECB was ready to put in place a broad-based asset purchase programme if downside risks to inflation materialised. Our base case is that a moderate recovery and a bottoming out of inflation this year, followed by a slow rise next year, will allow the ECB to sit on its hands for a very long time. It is unlikely to raise interest rates in 2015 and possibly also not in 2016.