When to End Monetary Easing and Bring in the Technical Rate Cut
June 26, 2009
By Tevfik Aksoy | London
Will the Central Bank of Turkey (CBT) stop monetary easing? In general, three issues surround the path of monetary policy: i) inflation outlook and expectations; ii) prevailing market liquidity and liquidity management in the market; and iii) growth prospects and the timing of any demand recovery. While all of these factors are broadly expected to play a key role in the final shape and duration of monetary policy, there is some debate around the timing of the much-talked-of ‘technical rate cut'.
Inflation to remain tame: There is a widespread view among market participants that inflation will remain tame in the next 12 months. This view is partly a result of an apparent lack of domestic and external demand pressures, we think, motivated by the CBT's effective communication. While the former is not a new development, the latter may be regarded as a significant success, reflecting a perception that the CBT's monetary easing of 800bp since last October had merits and that the bank was ahead of the curve all along. We also expect inflation to remain tame throughout the year; in fact, our year-end forecast, at 5.2%, is noticeably below consensus (6.2%). We expect inflation to rise gradually, owing the change mostly to base-year effects and a slight pressure from a demand pick-up, to 6.2% in 2010, which is more in line with the consensus of 6.6%.
More cuts on the horizon? The market is divided: We feel that the CBT has done an excellent job as far as the timing and extent of monetary policy are concerned. While there could still be limited room to ease without causing a marked impact on the market and/or macro fundamentals, we believe that now may well be the right time to stop.
At 8.75%, the policy rate stands at a record low, clearly underscoring the lack of inflationary pressures and significant slowdown in economic growth. We expect that almost all macro indicators will point to an improvement in growth prospects and that, after the dissipation of base-year effects from the CPI index, inflation will first reach a plateau before gradually rising in the coming months. At this juncture, the upside risks clearly outweigh the downside, in our view, given the behavior of commodity prices, possible fiscal measures and the expected improvement in consumer sentiment. As attested by the CBT's fortnightly survey of expectations, market expectations seem to be divided between a 25bp cut and a decision to stay on hold in the next three months. Hence, whatever the CBT decides to do at its July 16 MPC meeting, we think it is unlikely that there will be a noticeable market reaction.
Policy finds very little traction: While the market reaction to one more rate cut or an on-hold decision may be muted, our observation is that the policy has found very little, if any, traction over the past six months. The bank lending rate has not been rising in any meaningful way and the main funding costs of local banks - i.e., cost of time deposits - have not been falling. The former is clearly a function of an array of factors, such as consumer sentiment, borrowing costs, perception of creditworthiness and risk appetite, whereas the latter depends on retail consumers' choice of the level of currency substitution (that is, banks cannot risk losing TRY-based deposits to FX in case the interest rates they offer fall below their ‘reservation level'). Hence, the CBT may cut rates even more aggressively, and this may not have an impact on bank lending for an indefinite period. This is why we expect the CBT to hold rates and avoid taking unnecessary risks such that the possibility of falling behind the curve is avoided. The consensus expectation is that the CBT will hike rates by some 130bp in the next 12 months; this is in line with our view but a little less aggressive, as we pencil in some 150bp (225bp for the full year in 2010).
Do not be surprised: it is merely a technical rate cut. The CBT has repeatedly mentioned that a "technical rate cut" will be on the cards once the timing and the market conditions are ripe for implementation. By ‘technical rate cut', we understand that the CBT will readjust the borrowing and lending rates such that the mid-level corresponds to the prevailing repo lending rate in the market (the one-week repo rate is currently around 8.9%). Assuming that the currency spread between the borrowing and lending rates is preserved at 250bp, this would mean that the ‘adjusted' CBT policy rate(s) would be 7.5%/10.0%. If the CBT decided to cut one more time to lower the current policy rate to 8.50%, the technically adjusted rates would be 7.25%/9.75%. The underlying assumption is that the average policy rate would be more or less equal to the repo rate. Essentially, this would be a cosmetic change (the repo market will remain functional) rather than a fundamental alteration, but at least more realistic in a sense to reflect the true nature of the prevailing policy rate.
Whether the CBT decides to implement the change in July or August or postpone it indefinitely may depend on two things: 1) the timing of when the monetary easing ends; and 2) if and when an IMF Stand-By Arrangement is signed, such that the rollover ratio of the Turkish Treasury could be lowered and hence the liquidity conditions in the market change.
Important Disclosure Information at the end of this Forum
Fed Exit Strategy: When and How?
June 26, 2009
By David Greenlaw | New York
The Federal Open Market Committee meets this week and is confronted with a number of confusing signals from the markets. Since the last gathering in late April, Treasury yields and mortgage rates have risen, but are off of their peak levels of a few weeks ago. Survey and TIPS-based measures of inflation expectations remain relatively benign, but a weak dollar and rising commodity prices appear to be triggering some inflation concerns. Also, shortly after the release of the employment report for May, the markets started pricing in a significant amount of Fed tightening by early 2010 - that was too much and too soon, from our perspective.
FOMC likely to reiterate its commitment to keeping policy rates low for an "extended period". The FOMC is expected to reiterate that the fed funds rate target should remain low for an "extended period" dependent on economic conditions. This is consistent with our own view that a hike in the federal funds rate target will not occur until mid-2010. The Bank of Canada has made a more specific pledge to keep its overnight rate on hold until 2Q10, and some observers have suggested that the Fed should offer similar clarity on its intentions. However, we doubt that the Fed will cite a particular date since such a shift would appear to weaken the conditional aspect of the pledge and foster inflation fears which could lead to upward pressure on long-term interest rates. Indeed, we don't anticipate any substantive change to this part of the FOMC statement.
Altering the composition of its purchase programs could be discussed. At this meeting and future sessions, the FOMC will probably consider steps to address the back-up in mortgage rates by altering the composition of its purchase programs - that is, buying more Treasuries and fewer MBS. This would reflect the fact that mortgage rates are well off their recent lows even though spreads have tightened to near normal levels. However, while such a shift is possible - perhaps even likely - at some point down the road, we believe that changes along these lines probably won't be implemented at this time. Instead, we suspect that the New York Fed may adjust the targeted maturity mix of the Treasury purchase program by buying more long-maturity Treasuries and fewer short-term issues. Such a shift does not require FOMC approval and is therefore unlikely to be referenced in the official statement.
Questioning the Fed's credibility on the recent behavior of its balance sheet appears to be based on some myths. As mentioned earlier, Treasury yields have risen over the past few months, and this has helped to push up mortgage rates. While some claim that the jump in yields may be due to Fed credibility concerns, such a perception appears to be based on several myths regarding the Fed balance sheet. Specifically, there are contentions that the Fed is monetizing Treasury debt. Yet, the volume of Treasury securities held by the Fed today is far less than two years ago. Critics of this argument may counter that it's not just holdings of Treasuries that are fanning inflation fears; it's the acquisition of massive amounts of other types of securities, such as agencies and MBS. However, this view doesn't appear to hold water either. Fed assets shot up when it started quantitative easing (QE) last September, but the size of the balance sheet is lower now and has been shrinking even as Treasury yields were moving higher. By the way, the sharp decline in Treasury holdings that occurred between late 2007 and mid-2008 reflects the sterilization of the new liquidity facilities that were being introduced in response to the credit turmoil. In other words, as the Fed created programs such as the TAF, PDCF and CPFF, it would sell Treasuries to offset the impact on its balance sheet. It stopped sterilizing - and therefore started QE - in September 2008.
Perhaps it is the potential for future growth in Treasury purchases and/or the Fed's overall balance sheet that might be leading to credibility concerns? Admittedly, the purchase programs are only one-half complete for Treasuries, or less than one-half complete for agency and MBS. Shrinkage in other components of the Fed's balance sheet should continue to act as an offset to future open market purchases, but we suspect that a refinement of Fed communication on the exit strategy could prove helpful in addressing lingering credibility concerns and reducing long-term inflation premiums.
Three phases of an exit strategy. In our view, there are three phases of an exit strategy: passive, active and rate hikes. Some of the special liquidity facilities that were introduced by the Fed in response to the credit turmoil will wind down of their own accord - indeed, several of the largest programs are already showing such a pattern. This is what we refer to as a ‘passive' exit. Other programs, such as the Treasury, agency and MBS open market purchases, will require a more active approach. While we view outright sales as unlikely due to potential significant market disruption and political constraints tied to recognizing loses, there are several other tools that might be employed (such as reverse RPs, expanded SFP bill issuance, reserve requirement changes, etc.). The Fed can and should provide specifics on its approach to the ‘active' portion of the exit strategy in the not-too-distant future, in our view. Also, the Fed will likely need to adopt tools that will allow it to push the fed funds rate higher prior to complete exit from QE. As we learned in late 2008, the interest on reserves program does not necessarily put a hard floor under the federal funds rate. Although the Fed believes - and we concur - that this was partly related to unusual pressures on bank balance sheets, the Fed's credibility could receive a boost if it took steps aimed at avoiding a repeat of this problem. This might be done, for example, via an expansion of the interest on reserves program to non-bank institutions or by prohibiting some entities from participating in the federal funds market.
While the FOMC could conceivable include a reference to the exit strategy in the official statement, it might be best to deal with any substantive communication on this front at Bernanke's upcoming Monetary Policy Report to Congress, scheduled for July 21.
From a broader perspective, the Fed certainly stands ready to do more if progress towards economic recovery shows signs of faltering. But in the absence of any clear-cut signals from the incoming data or the markets, they are likely to take a wait-and-see approach for now.
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. Incorporated, and/or Morgan Stanley C.T.V.M. S.A. and their affiliates (collectively, "Morgan Stanley").
Global Research Conflict Management Policy
Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.
Important Disclosure for Morgan Stanley Smith Barney LLC Customers
The subject matter in this Morgan Stanley report may also be covered in a similar report from Citigroup Global Markets Inc. Ask your Financial Advisor or use Research Center to view any reports in addition to this report.
Important Disclosures
Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.
Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.
As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.
|
![](/img/clear.gif"){kind=spacer}