A Different Unconventional Measure
May 01, 2009
By Manoj Pradhan & Joachim Fels | London
Committing to low rates for longer: Apart from slashing short-term policy rates – the conventional tool of monetary policy – major central banks have adopted various unconventional monetary policy tools in the ongoing turmoil. Quantitative easing and credit easing in their various forms have understandably garnered most attention – for our latest update on these, see last week’s The Global Monetary Analyst. Today we focus on another type of unconventional policy, which seems to have become more popular with some central banks recently as they reach the effective lower bound for the policy rate – an explicit commitment to keep the policy rate low for a longer period than previously expected. Central banks that have employed this tool recently include the Fed (since December), the Bank of Canada and the Swedish Riksbank (both from last week). The ECB may follow next week. If credible, such a commitment should lower yields through the term structure and support other asset prices.
Policy commitments to keep interest rates low for a long time are not without precedent – both the Fed and the Bank of Japan used this tool to influence interest rate and inflation expectations earlier this decade. For example, on March 18, 2001, with its policy rate virtually at zero, the Bank of Japan switched to targeting banks’ reserves held at the central bank and promised to keep this policy in place “until the consumer price index (excluding perishables, on nationwide statistics) registers stably a zero percent or an increase year on year”. Another example is the August 2003 FOMC statement, where the Committee said that “policy accommodation can be maintained for a considerable period”. Commitments are conditional: It is important to note that, in both cases, the policy commitments were conditional in the sense of linking the duration of promised policies not to the calendar but to economic conditions. The conditional nature of the Fed statement was sharpened in December 2003, when the FOMC explicitly linked continuing policy accommodation to the low level of inflation and the slack in resource use. Similarly, the recent commitments by the Fed, the Bank of Canada and the Swedish Riksbank are also conditional in nature: • When the FOMC cut the target for the funds rate to 0-0.25% on December 16, 2008, the statement included the following phrase: “[T]he Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.” Thus, the commitment was linked to the continuation of weak economic conditions. This was repeated in the February 2009 statement, but slightly amended in the March 18 statement to: “The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” The latter sounds like a commitment to keep rates lower for longer, because it omits the adjective “weak” before economic conditions and because it replaces “for some time” with “an extended period”. • Last week, the Bank of Canada cut its target for the overnight rate to what it calls an “effective lower bound” of 0.25% and added that “with monetary policy now operating at the effective lower bound for the overnight policy rate, it is appropriate to provide more explicit guidance than is usual regarding its future path so as to influence rates at longer maturities. Conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target. The bank will continue to provide such guidance in its scheduled interest rate announcements as long as the overnight rate is at the effective lower bound”. • On the same day, the Swedish Riksbank lowered its repo rate to 0.5% and added in the statement that “the repo rate is expected to remain at a low level until the beginning of 2011”. This is a conditional commitment, too, because the expectation is based on the bank’s current projections for inflation. • When the ECB decides on policy rates next week, a commitment to keep the refi rate low along similar lines to the other central banks cannot be ruled out. If enacted, it could provide the ECB with another alternative measure to avoid using active quantitative easing to purchase assets. More than a Taylor rule? Given that most commitments depend on the behaviour of inflation, one could ask if this ‘commitment’ is anything more than a ‘Taylor rule’. The traditional Taylor rule says that policy rates should be guided by the output gap and where inflation is relative to its target level. Given the severity of the shock to the real economy and on basis of the weak outlook for the global economy on our forecasts (see “Green Shoots to Bear Fruit?” The Global Monetary Analyst, April 15, 2009), the output gap is unlikely to be the reason that policy rates are raised. A commitment to low interest rates could then amount to ignoring output growth in the current environment and keeping the door open for rate hikes should inflation rise for any other reason. There are other issues regarding the use of such policy measures: First, the commitment has to be for an appropriate period of time. Committing to low interest rates for three or even six months is unlikely to have much of an impact because markets already expect that central banks will stay on-hold for that long before hiking rates. Committing for too long could lead markets to focus more on the conditional aspect of the commitment and determine for themselves how long policy rates will stay on hold. Second, the willingness to use policy measures depends as always on whether they are likely to provide tangible benefits. In the present context, a commitment to low policy rates makes most sense when household and/or corporate borrowing is tied to front-end rates. However, given the severity of the shock, the global policy machine has attacked the problem from all flanks. It is not surprising therefore that the Fed and (maybe) the ECB are considering a commitment to low policy rates even though the most important borrowing rates in those theatres are long-term rates. Complementing QE: Despite these concerns, policy commitments could be very useful in providing credible guidance to markets as part of a policy to lower interest rates of slightly longer maturities than the next few months. In fact, the strategy could prove to be even more effective in combination with active QE purchases of long-term assets, putting downward pressure on long-term rates (as we discussed last week). Effectively, the combination would shift the yield curve lower and make borrowing cheap at nearly all maturities. Policy rate commitments therefore need not be substitutes for quantitative easing, but could actually be used very well in conjunction with QE. Valuable as part of an exit strategy: Interestingly, where such policy commitments could be invaluable is not to push rates even lower now, but to keep rates from rising too fast when central banks believe that it is time to move rates away from zero and/or unwind the quantitative easing regime. Raising policy rates above zero but still well below neutral along with a credible commitment to keep them there would keep markets from pricing in rate hikes all the way back to neutral. Similarly, plans to sell purchased assets in tranches with a commitment to conduct such sales with significant pauses in-between could keep the relevant rates and spreads from rising rapidly. Absent such commitment, the erosion of the flight-to-quality bid, higher medium-term macroeconomic risks, inflation risks and rising policy rates could make for a lethal cocktail of rapidly tightening financial conditions that could well undo all the good work done so far.
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100bp Cut Despite Deteriorating Inflation Outlook
May 01, 2009
By Michael Kafe, CFA & Andrea Masia | Johannesburg
The South African Reserve Bank (SARB) cut its policy repo rate by 100bp to 8.5% on April 30. This exceeded our 50bp base case but was in line with market expectations. The full percentage point rate cut appears to have been driven almost entirely by a deterioration in the country’s growth outlook. What is most interesting to us is the fact that, although the SARB seems to suggest that a widening output gap should help cap inflation pressures, its forecasts show that cost-push factors are likely to outweigh the potential benefits from weak demand-pull pressures. This implies willingness by the SARB to accommodate a higher inflation trajectory, with the aim of supporting domestic growth, and suggests that it may be willing to cut rates even further – perhaps in clips of 50bp at each of the upcoming MPC meetings in May and June. Commitment to G-20 Directives The opening paragraph of the MPC statement lays the groundwork, with bearish commentary on its view of a severe synchronized global downturn, and explains that “the G-20 countries, including South Africa, have committed themselves to a program of action in order to contribute toward the earliest possible global economic recovery”. The latter comment suggests that the motivation behind the MPC’s policy actions may stretch beyond domestic considerations and points to renewed willingness by the MPC to participate in the synchronized policy easing that its global peers have long embarked upon. Negative Output Gap to Cap, Not Reduce Inflation As far as inflation is concerned, the MPC admits that a widening domestic output gap will not be able to fully contain inflation pressures in 2009/10, and has adjusted its forecast accordingly. Although the statement does not explicitly mention that the MPC no longer expects inflation to dip below 6%Y in 3Q09, the fact that it is now silent about this suggests to us that it no longer expects CPI to re-enter the target band as early as was predicted in March. Our own forecasts show that, once one adjusts the inflation profile for the upside surprises in 1Q09 CPI, targeted inflation is now likely to come in around 6%Y in 3Q09. Second, the statement no longer alludes to a return to target range by 2Q10. It is possible that once it incorporated its “revised assumptions about administered prices and the higher-than-expected outcome for February”, the MPC’s inflation forecast no longer shows a dip below 6%Y in 2Q10. Our own forecasts show an average reading of 6%Y in 2Q and 3Q, before closing the year at 5.7%Y. Third, the MPC’s trajectory now shows that CPI is expected to average 5.4%Y in 4Q10. This is a slight upward revision from the 5.3%Y published at the March MPC meeting, despite the fact that the currency has appreciated by more than 8% since then. This is explained by the upward revisions that it has made to its administered price assumptions – presumably electricity tariffs. We believe that 5.4%Y is still optimistic, and that the MPC may not have priced in a higher-than-usual increase in June 2010 rental costs. (2010 FIFA World Cup games will be held in June. This is a key risk area that may result in further upward adjustments to the SARB’s 2010 inflation profile at upcoming MPC meetings.) Looking Forward That the MPC statement focused on the deterioration in global and domestic growth prospects without further addressing the deteriorating inflation profile suggests to us that it is seriously concerned about GDP growth. We surmise that it may be willing to ease rates further, despite what appears to be structurally higher inflation. Our GDP forecasts show that domestic growth is likely to remain in negative territory until 3Q09, and we believe that the SARB may be willing to engineer two more interest rate cuts in May and June. However, we think that the sizes of these cuts are likely to be smaller (50bp), for two reasons: 1) We believe that the currency’s recent appreciation is overdone and is likely to correct in the coming weeks. A depreciating currency should present enough upside risk to the inflation profile to warrant conservatism. 2) To continue cutting rates aggressively while the inflation trajectory deteriorates could put the SARB’s hard-earned credibility at risk, in our view. We believe that the MPC will take this into account in its decision-making process.
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