Central Banks: Mind the Divergence

The global economy is slowing, following a synchronized cyclical upswing in 2018 driven by a procyclical U.S. fiscal stimulus. Since then, a trade war between the U.S. and China has stalled global momentum, with global PMIs bearing the brunt, businesses postponing investment decisions and Central Banks easing monetary policy as a result. Despite their best attempts to sustain the expansion, Brexit’s twists and turns have caused uncertainty to persist, adding to Eurozone and global woes.

Paxforex

The ECB’s Mario Draghi’s exit marked extraordinary stimulus, cutting interest rates by 10bps to -0.50% and restarting monthly asset purchases to the tune of €20 billion. The decision was met with dissent — justified or not — it's a double edge sword, which allows inflation to converge towards the ECB’s target but lessens its ability to respond to a crisis, as I argued here. Meanwhile, the FED has lowered the Fed funds rate twice, to 1.75% — 2.0% and is turning preemptive in the face of global headwinds.

Emerging Markets (EM) Central Banks follow the Fed and ECB dovish trend

Following the FED’s doveish tilt, global Central Bank’s have followed suit, with the Banco de Brazil cutting interest rates by 150 basis points (bps) to 5.5%, Banco de Chile by 100bps to 2.0%, Banco de Mexico by 50bps to 7.75%, Hong Kong by 25bps to 2.25, Indonesia by 75bps to 5.25%, India by a similar amount to 5.25%. Similarly, the South African Reserve Bank and Bank of Korea have cut rates by 25 bps to 6.5% and 1.5% respectively. The Russian Central Bank cut to 7.0% on September 6th, following the dovish trend from the Fed and ECB. Most Central Banks judge it necessary to cut their policy rates due to persistent global risks, ranging from the U.S.-China trade war, the South Korean — Japan spat, geopolitical uncertainty in the gulf, negative-yielding debt, Brexit and a slowdown in global growth. It is, however, becoming increasingly important to balance these against financial stability risks as well as their ability to respond to a future downturn.

Em Central Banks — Slowing growth and the dollar-driven response function

The extent of rates cuts merely reflect interest rate differentials and an unwillingness to allow EM-currencies to strengthen at a time of slowing global momentum; the balance between interest payments & debt sustainability as well as export competitiveness is less nuanced, given the context. Most emerging market economies would rather boost export competitiveness rather than worry about debt sustainability as Developed markets will likely be lower for longer.

Nevertheless, another trend is visible here. Even as the world has become increasingly multipolar, the dollar’s dominance persists. Admittedly, 50% of global trade is invoiced in dollars, despite this being five times the size of its economy and three times more than its share of global exports. Furthermore, 2/3 of Em issuance, external debt, and official reserves are denominated in dollars. As such, although EM central banks have explicit inflation targets, their response functions to macroeconomic developments are increasingly dollar-linked. This explains the global trend of easing, to a large extent, even as the synchronized global slowdown likely has some bearing in most EM central banks' decision making.

Inflation targeting versus financial Stability.

I have written at length of the need to balance inflation targeting against financial stability risks, which inevitably results in ultra-accommodative policy or negative interest rates. The post-crisis years have normalized unorthodox monetary policy — characterized by negative interest rates and bond purchases — depleting Central Banks’ policy toolboxes and causing renewed worries about their ability to respond to a future downturn. There is very little room for central banks to cut interest rates in the event of a downturn, as interest rates are currently close to the zero lower bound. During the 2008 GFC, short term interest rates were cut in the Euro Area, Norway, Sweden, Switzerland, and United Kingdom by 400bps, 500bps, 420bps, 330bps, 490bps respectively. Norway and Sweden appear to have cut interest rates more aggressively given their levels of interest rates at the time. This allowed inflation to rise back towards their 2.0% target at a faster pace and enabled them to diverge from the current trend of monetary easing. A similar trend is not unlikely in the event of a downturn, which might explain a less marked obsession over the inflation target.

By no means does a pause in the face an inflation overshoot mark less commitment to their inflation target, but Central banks must now conduct monetary policy in a manner that enables them to respond to a downturn and guide market expectations more closely. This pragmatism will become increasingly evident in the event of a downturn, where central banks’ monetary policy tool kit will be increasingly tested. One can, therefore, ascribe some pragmatism to such an approach, as lower interest rates will undoubtedly stimulate the economy, but the headwinds from rising risks of protectionism and political uncertainty might lean against the expansionary effects of monetary policy at this point. Although central banks will seek to preempt rather than respond to a crisis, the blurry transmission mechanisms caused by global trade uncertainty and other headwinds should at the very least inform current thinking on the design and delivery of monetary policy.

As illustrated in the chart, inflation is poised to remain close to target in Norway and forward rates will continue to rise, albeit at a more gradual pace among some advanced economies (see chart). Norges’ Bank’s approach to interest rate hikes is justified by the persistence of underlying inflationary pressures, which are poised to remain close to targe throughout the forecast period. If anything, monetary policy seems to be adapting to an environment where inflation is increasingly driven by oil prices. Such an approach will allow policy rates to move away from the zero lower bound and allow a more targeted response to a financial crisis. I argued in a recent paper that Centra Banks should rethink their inflation targetting approach and lessen dependence on oil.

Admittedly, other factors facilitated the convergence of inflation towards the 2.0% target as I argue here. Nevertheless, their decision to diverge from the global trend of easing will facilitate a more aggressive response to a downturn and achieve their mandates sooner. Forward rates are much lower than the start of the year, but they appear to have fallen more markedly in the Euro Area and the United States, which is symptomatic of the waning impact of the fiscal stimulus, trade tensions and a slowdown in global growth. Meanwhile, forward rates in Sweden have fallen more slowly, reflecting a still strong, albeit slowing economy, and close-to-target inflation.

Similarly, the Riksbank — central bank of Sweden- is poised to raise interest rates in December 2019. The 25bps to 0% will move interest rates, which have been in negative territory since the onslaught of the financial crisis. Furthermore, the slowdown in the global economy implies a normalization of economic activity and inflation — whilst slowing in recent months — will remain close to the Bank’s 2.0% target. Meanwhile, the Bank is purchasing government bonds for a nominal amount of Sek 45 billion with effect from July — Dec 2020. The low level of interest rates and continued liquidity will support economic activity and ensure inflation rises sustainably towards their 2.0% target. The Bank’s forecast judges current monetary policy to be broadly appropriate and minimal contributions from oil to underlying inflation (CPIF) suggest a more forward-looking approach to inflation (see chart).

The macroeconomic backdrop is ridden with risks, which complicates monetary policy at a time when Central banks’ ammunition might be running low. As such the Norges Bank and Riksbank are justified in their preemptive approach to setting interest rates, but the structural differences amongst global economies might explain the more conciliatory approach from the Fed and ECB. Both central banks appear focused on maintaining the current expansion, but calls for fiscal policy might prove futile if their design isn’t debated ahead of the oncoming slowdown. If Central Banks fail to balance financial stability against the need to attain their inflation targets, they will be increasingly beholden to fiscal policy.

I am an economist and contributor to Nkafu policy, a think tank. I cover global economic, fiscal and monetary policy with policy and asset price implications.

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