Gilt Yields and Monetary Policy
Aug 24, 2006
David Miles (London)
Where are we today?
Yields on gilts with maturities beyond about four years are currently below the Bank of England’s repo rate, which since early August has been at 4.75%. Taken at face value — that is, interpreted as an implied expectation of future monetary policy — those yields suggest that the Bank of England will cut rates at some time over the next few years and that rates will be below the current level for much of the next five years and beyond. Forward rates give a clear indication of this. The Bank of England estimates forward rates based on gilt yields. The 5-year forward rate is effectively an overnight rate five years ahead. In describing these calculated forwards, the bank says that these are “…instantaneous forward rates, i.e., the implied interest rates on future transactions with infinitesimal investment periods. In practice these can be identified with expected future overnight rates”. At the five-year horizon, the forward rate is around 4.5% (as of August 21); at the ten-year horizon, the forward rate is just under 4.3%. What it takes to justify current 5-10-year yields These forward rates reflect not just expectations of future short-term rates; they also include term (or risk) premia. So it is not quite so straightforward to read off an implied expectation of the stance of future monetary policy from the forward rate. Nonetheless, at least one of the following four things must be true: 1. The neutral rate — that is, the level of the repo rate consistent with monetary policy being neither accommodative nor restrictive — is under 5%. This would mean that a repo rate of under 5% is sustainable and so the 5 and 10-year forward rates could naturally sit under 5%. OR 2. The neutral rate is not under 5% but monetary policy needs to be accommodative for much of the time over the next five years and beyond. This would imply that the economy will go through a very extended soft patch a few years down the road. OR 3. There are significantly negative term premia (or risk premia) on gilts with maturities of more than a couple of years. This would mean that yields on bonds with maturities in the 5-10-year range could be below the anticipated average level of the Bank of England’s repo rate. OR 4. Something else is going on — for example, that expectations about the neutral rate, or about the extent to which policy will deviate from a neutral level, are not consistent with the evidence. These justifications aren’t convincing We believe that ‘explanations’ 1-3 are not very convincing. Our thinking on the neutral rate was set out a couple of months ago (see The Direction of Monetary Policy in the UK, David Miles and Melanie Baker, May 4, 2006). We argued that a range of different pieces of evidence suggested that a neutral level of the repo rate was likely to be close to 5%. The Bank of England’s subsequent Inflation Report seems to be consistent with the idea of a neutral rate at or above the current repo rate. The Inflation Report is also not consistent with the idea that policy is likely to be — on average — accommodative over much of the next few years. So we do not consider ‘explanation’ 2 above very plausible either. Nor do we find the argument that term (or risk) premia on short and medium-dated gilts can be significantly negative very plausible. Our empirical work gives estimates of term premia on 5 and 10-year gilts that are small and generally positive; they would need to be substantially negative for ‘explanation’ 3 to work (see What Is Happening to the Risk Premia on Bonds? Vladimir Pillonca and David Miles, June 14, 2006). While there is a plausible story that pension fund asset-liability matching may have created a premium on long-dated gilts (implying a negative risk premium for long bonds), we think it is not very likely that this is having a big effect on bonds with durations of only five years or so. So, by a process of elimination, we believe that ‘explanation’ 4 is the most likely: something else is going on. This could mean that expectations about the neutral rate are, on average, too low or that views about the extent to which policy will deviate from a neutral level are not consistent with the evidence. Either of those things is likely to mean that yields and forward rates at the 5-10-year horizon are more likely to move up than fall. This is what is built into our central forecast for rates, which is that yields on 5 and 10-year gilts move up above 5% by the end of this year.
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Reality Check
Aug 24, 2006
Serhan Cevik (Turkey)
Should the Central Bank of Turkey keep raising short-term interest rates? The majority of market participants anticipate a 25bp hike this month and more in the remainder of the year. Although we do not agree with the underlying argument for such projections, the consensus view is not based on an unsubstantiated expectation. The Central Bank of Turkey, after raising short-term interest rates by 400bp in a month to prevent a vicious cycle in financial markets, has adopted a hawkish stance and made an obvious commitment to further monetary tightening. In our view, however, the new fine-tuning campaign would have no material effect on economic behaviour and therefore is simply an attempt to regain credibility via over-tightening. But is it wise and, more importantly, effective to overlook macroeconomic factors and to give an unwarranted weight to market expectations in the policymaking process? We think not. Keeping inflation expectations anchored to the targets is certainly an important task for an inflation-targeting central bank, but blindly following adaptive and biased expectations would not only increase uncertainty, but also harm policy credibility in the longer term. Unfortunately, even though there is no macroeconomic justification for further tightening of the monetary policy stance, the central bank has already put itself in a corner by over-emphasising the role of expectations. It seems that policy rhetoric is back to the early days of the disinflation programme. After the crisis, not many people, including the central bank management, believed in the power of macroeconomic normalisation. That was why short-term interest rates remained, for a long time, excessively high relative to structural changes in the economy that brought inflation down to the lowest level in decades. Under-appreciating the extent of fiscal consolidation and disregarding productivity improvements, policy rhetoric focused on “bringing inflation expectations in line with the targets” and consequently contributed to some of the excesses that are still problematic for the whole economy (see Wag the Dog, May 8, 2003). And now, after a painful stabilisation period, it seems that we are back to the early days of the disinflation programme, with a growing emphasis on contemporaneous inflation and market expectations. But what about the effects of the volatility shock on the rest of the economy? Although Turkey has suffered from a series of supply-side shocks and lately from the lira’s sharp depreciation, the (im)balance between supply and demand is the ultimate determinant of inflation dynamics. Therefore, we need to keep looking into the real economy in order to figure out the inflation outlook beyond a month or two. The moderation of domestic demand should limit the pass-through to consumer prices. One of the most powerful channels of macroeconomic normalisation is the rise in productivity growth, and the latest figures confirm the secular expansion of the supply frontier and the continuing strength of the real economy. Industrial production, for example, increased by 11.4% year on year in June and 6.5% in the first half of the year. Of course, the recent volatility in financial markets may slow the production cycle in the near future, but the important point here, at least for the inflation outlook and monetary policy, is the interaction between the accumulated increase in the country’s productive capacity and the slowdown in private consumption. Indeed, the behaviour of consumer spending is the key to inflation dynamics and therefore to interest rates. With the market turmoil and more restrictive financial conditions, the consumer confidence index dropped by 7.0% year on year in June and then 10.7% last month to its lowest reading in years. As a result, consumers have tightened their belts and retail sales recorded a sharp drop across the board. For instance, automotive sales declined by 41.9% in July compared to a year ago, confirming the moderation of domestic demand that will limit the pass-through from currency depreciation and higher production costs to consumer prices. Monetary policy cannot be an answer to structural and institutional problems. In our opinion, the widening output gap points to substantial slack in the Turkish economy, while growing competitive pressures effectively lower the rate of price increases, especially in the tradable sectors of the economy. This is why we still expect the return of convergence towards the ‘price stability’ range over the medium term and so argue in favour of keeping short-term interest rates unchanged for the remainder of the year. However, recent developments have clearly shown to us that macroeconomic policies have diminishing returns and cannot be an answer to problems that are structural and institutional in nature. Take, for example, oligopolistic market structures and international trade barriers, which we have long identified as obstacles for productivity growth, disinflation and sustainable stabilisation (see The Microeconomic Limits of Disinflation, February 18, 2000). Likewise, artificial wage adjustments in the public sector that are not consistent with the overall macroeconomic framework keep distorting the labour market and slowing the pace of disinflation. This is why Turkey needs not just prudent macroeconomic policies, but also structural reforms that would help to rejuvenate and strengthen the economy at the micro level.
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How High Could Rates Go?
Aug 24, 2006
Andy Xie (Hong Kong)
Summary and conclusions China’s growth environment most resembles that of Korea and Taiwan in the 1980s, but its real rates are 4-5 percentage points lower than in either market at that time. This suggests that China’s interest rates should rise by that much to contain its overheating. Despite exceptionally low real rates, China’s inflation rate is still relatively low. Two special factors may explain this. First, the low inflation is partly an illusion as, while China’s household sector is not overheating, the government-driven investment sector is. Second, China’s government sector has numerous channels with which to tax the household sector to fund investment, which depresses consumption demand and increases supply capacity. As China expects little short-term harm from the overheating, the tightening is likely to be mild and should do little to ease the overheating. This could lead inflation in the US to rise more than expected, and the Fed to tighten much more. The effective tightening on China would then come from a slowing US economy. Interest rates are too low relative to growth China’s development model bears the greatest similarity to that of Japan, Korea and Taiwan. Thus, the level of interest rates in these economies during their high growth phase could shed light on where China’s rates should be. China’s current growth phase most resembles that of Korea and Taiwan in the 1980s. Its export sector resembles Taiwan’s OEM model; its fixed investment sector is similar to Korea’s chaebol model; and China has pushed the export-investment growth model further than both. Real interest rates in China, loosely defined as nominal rate minus GDP deflator, are 4-5 percentage points lower than that in Korea or Taiwan in the 1980s. This gives us a rough sense on where China’s interest rates should be. In the 1960s, Japan experienced a high growth rate similar to China’s today. Its real rates were lower than Korea or Taiwan’s in the 1980s, but were still much higher than China’s now. The Japan example suggests that China’s rates should rise by three percentage points, in my view. Government power can hold back inflation temporarily… In an investment-led economy, inflation is not the only indicator of overheating; it may not even be the primary indicator. In the East Asian export/investment-led growth model, an all-powerful government is a necessary condition. But, government power can substantially distort the behaviour of macro indicators. Inflation in particular can be kept artificially low, and does not necessarily reflect the aggregate demand-supply balance. One distorting factor is the government’s ability to raise the savings rate. In that regard, the Chinese government is far more powerful than Japan or Korea’s. Beijing controls most key assets like natural resources, land, banks, telecommunication and utilities. It can change prices to raise national savings. China’s gross savings rate has risen to an estimated 50% of GDP in 2006 from 41.8% in 2002 (when the current growth cycle took off). The rising savings rate has shifted demand growth to investment, which is less inflationary as it creates capacity. Most inflationary pressure tends to come from raw materials as China has limited ability to increase its supplies. Between 2002 and 2005, China’s GDP deflator averaged 4.9%, compared to 2.3% for CPI inflation. While the GDP deflator is a better indicator of inflationary pressure in China’s model, it is still relatively low. China’s economy is growing at a double-digit rate. The one-year deposit rate is only 2.5% — after a 20% interest income tax, it is 2%. Other economies with such attributes would have a double-digit inflation rate. As the economy overheats, China can therefore shift demand to investment, which leads to more capacity and is less inflationary. …but inflation will find a way Raising the savings rate has the effect of making monetary growth less inflationary. It can seem to belie the conventional wisdom that too much money leads to inflation. But, a rising savings rate just pushes inflation from consumption to where there are temporary bottlenecks. Property, for example, takes three years to complete and, hence, prices can inflate despite rising construction. And, as price momentum sucks in more buyers, the completed properties that went into production three years ago are insufficient for current demand. Hence, prices keep rising and more buyers are sucked in. As price and volume rise strongly and together, market analysts interpret the market as driven by ‘fundamentals’. It is actually just a monetary phenomenon. I believe that most excess money supply in the world and in China has gone into this sector. Skilled labour is another bottleneck that has attracted the second biggest share of excess money supply. While China’s college graduates have seen starting salaries decline during the boom, experienced managers have seen their salaries reach international levels. Oil is another area where inflation shows up. Most oil is supplied by government-owned entities that do not increase supplies quickly in response to rising prices. Hence, it has the potential to attract a big chunk of the excess money supply to inflate the oil price. While money supply may not inflate CPI first due to technical reasons, it goes to where the bottlenecks are. The rising prices in these bottleneck areas increase costs for the whole economy. The market misinterprets this inflation as being cost-push and expects it to go away over time. Rather, it is how money turns into inflation in a globalised economy. Cost-push inflation eventually turns into a wage-price spiral as workers realise that real wages are declining. We are not yet at this point in China. However, several economies are already close to or in such a situation already. Tightening on China will come externally China’s tightening pace is too slow to have a meaningful effect on demand. China is growing three times as fast as the US, has lower interest rates, and is raising interest rates slower. China is years away from a normal monetary environment, in my view. Instead, I believe that China will continue to use administrative measures to stabilize the economy when it threatens to boil over. But, administrative measures work through the fear factor, and its impact is not long-lasting. The government has to frighten the market every three or four months. Its effect is to keep the economy from boiling over without curing overheating. China’s overheating will end when all the excess liquidity has turned into buildings. Meaningful tightening on the Chinese economy should come from slowing exports, when the US’s housing bubble deflates and its interest rate is kept up by high inflation. China’s export production is about 20% of the economy in value added and contributes 3-4 percentage points directly to GDP growth. When its exports stop growing, China could still tap into excess liquidity to sustain investment growth — i.e., its interest rate will not normalise right away with an export downturn. China’s interest rates may rise to or above the neutral level only in 2008, in my view.
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