Europe
ECB: A Not So Easy Exit
July 09, 2009

By Elga Bartsch | London

A firm eye on the future exit from current policy measures: At the July press conference, ECB President Trichet insisted that all policy measures the ECB takes - standard interest rate reductions and non-standard liquidity instruments - were designed for an "easy exit".  The decisively dovish tone at that press conference implies that such an exit won't be implemented any time soon though.  In fact, the ECB seems to be content with the EONIA overnight rate settling below the refi rate for now (see ECB Watch: Steady Hands, July 2, 2009).  However, as financial markets are permanently pricing the probability of future events, it is important to start thinking through the eventual exit and what it might look like already now (see also Interest Rate Strategist: End of Easing: Implications, June 5, 2009).  This note outlines how such an exit could look for the ECB and how the different measures might be sequenced.  In our view, a credible exit strategy is also an important ingredient in the effectiveness of present monetary policy stimulus.  To demonstrate that one is able to act and exit swiftly, if needed, ensures that inflation (risk) premia will remain low when the economy starts to recover and that the whole yield curve stays well anchored. 

The ECB is usually more cautious on exit than entry: In principle, the entry and the exit should be symmetric for a central bank that has price stability as its primary objective and that claims to be as much concerned about inflation as it is about deflation. In monetary policy practice, however, entry and exit aren't symmetric.  Central banks tend to be more aggressive when it comes to interest rate cuts than they are when it comes to raising them again.  In the first ten years of its existence, the ECB has been no exception.  Even before the exceptional circumstances of last autumn, the ratio between small and large rate reductions was a balanced one.  Including the extraordinary action since last October, the ratio tilts to 2:1 in favour of large rate cuts.  However, when looking at past ECB tightening cycles, only two out of 14 rate hikes so far were large increases of 50bp (November 1999 and June 2000).  In this context, asymmetric arguments that stress the need to fight a perceived deflation danger at present at all costs and only worry about how to contain a potential future rise in inflation at a later stage worry us.  This is partially because we don't see any serious deflation danger in the euro area (see EuroTower Insights: Good Deflation Isn't a Cause for Concern, February 4, 2009).  Mainly, though, it is because we believe that fighting inflation will prove to be much tougher than in the past. 

Beware the policy asymmetry though: In our view, there are a variety of reasons why fighting inflation will prove to be harder in the future.  These include a less favourable trade-off between inflation and growth (if any such trade-off exists over the long haul), a limited influence of local central banks in a world of rising global inflation interdependencies, and a sharp deceleration in trend GDP and productivity growth rates in the years ahead (see various GMA reports over the past two years).  A further concern at this particular juncture relates to the still-fragile state of the financial system.  It is this fragility that could potentially limit the ability of central banks to single-mindedly nip emerging inflationary pressures in the bud.  The policy action over the last two years has underscored that central banks have a strong interest in safeguarding financial stability, if not an outright obligation to do so.  So, the challenge for central banks will be to counteract a potential rise in inflation expectations by raising rates without jeopardising healing in the financial sector.  In our view, the ECB's one-year tender allows to do exactly this.

Refi rate hikes before tender switches: For the ECB, who with its focus on passive quantitative easing (QE) stayed within its regular operational framework (see EuroTower Insights: Not Quite QE, May 13, 2009), the exit from its current policy stance should be straightforward.  We would expect the bank to consider interest rate hikes before reversing its non-standard measures, notably the covered bond buying programme, the fixed-rate tenders for its refi operations with guaranteed full allotment, as well as the wider collateral pool underlying these refinancing operations.  In terms of signalling its policy intentions, an increase in the refi rate would likely have the biggest impact.  At this stage, we would expect the ECB to start gradually raising interest rates in mid-2010.  By that time, the recovery should be well underway and on the policy-relevant time horizon - i.e., four to six quarters ahead - there should be less of a need for such an extremely low interest rate level. The two additional one-year refi operations the ECB will conduct in late September and late December, which will be offered at the refi rate of 1% plus a small spread, will likely be taken by the market as a first indication of how the ECB Council sees the refi rate evolving over the course of 2010.  Based on our own forecast profile, we would not be surprised to see a small spread of around 10bp in the September operation and 25bp in the December operation.

Draining liquidity before refi rate hikes: Ahead of actual hikes in the refi rate itself, the ECB would probably want to see the EONIA overnight rate come closer to the official rate again.  To some extent, this would happen automatically when banks are becoming less risk-averse, become more willing to lend to each other again and hence don't overbid aggressively at the refi tenders anymore.  Obviously, borrowing funds at 1% from the ECB only to put them back into the deposit facility at 0.25% is not a viable long-term funding strategy.  To some extent, aligning EONIA more closely with the refi rate again might also warrant some draining of liquidity by the ECB.  Even though the July press conference gave no indication that such regular draining of liquidity is on the cards in the near term, it still remains a measure available to the ECB.  Such draining of liquidity from the money market can be done via reverse tenders (such as the one the ECB regularly undertakes at the end of each maintenance period) where the ECB offers to take in funds for a certain period at a set interest rate (typically more favourable than the deposit rate of 0.25%) or via issuing debt certificates.  Reverse tenders are often used by the ECB for draining liquidity over a very short timeframe, and they would also be offered at longer maturities. The interest rate offered would typically be below the refi rate but above the deposit rate.  While the ECB has not issued any debt certificates yet, this is clearly an instrument at the bank's disposal (see The Implementation of Monetary Policy in the Euro Area: General Documentation on Eurosystem Monetary Policy Instruments and Procedures, ECB, November 2008).  Last but not least, the ECB Council could consider narrowing the corridor around the refi rate even further to limit the deviation of EONIA from the refi rate. 

Fixed-rate tenders insure against money market dislocations: Meanwhile, the current fixed-rate tenders with full allotment will probably remain in place for longer than the current refi rate level.  This is because a switch back to variable-rate tenders remains risky if money markets still don't function properly in channelling funding to where it is needed.  Hence, the ECB will have to ensure that it provides sufficient liquidity to all counterparties in case the market intermediation fails (again).  This can only be ensured with fixed-rate tenders and full allotment.  Using fixed-rate tenders with partial allotment, which were used by the ECB in the early years, are not an advisable alternative, we think, because banks will simply overbid at these tenders - like they did when this tender was in operation.  The decision therefore comes down to a fixed-rate tender with full allotment and a variable-rate tender where only bidders with the highest interest rate offers get filled.  Next to the tender type, the ECB will need to decide on whether to extend the time period over which the wider collateral pool can be used.  At the aggregate level, the high degree of over-collateralisation does not suggest that there is a shortage of collateral in the euro area financial system.  The situation might be different for individual institutions, though, but this is impossible to tell from official data.  Meanwhile, the ECB's covered bond programme, which is not a stimulus measure but structural support for a certain market segment, will likely be a ‘buy and hold' event.  In addition, ECB President Trichet has already indicated that this buying programme is meant to be conducted over a 12-month timeframe, which would mean that it would be completed in early July 2010. 

To sum up, we believe that the ECB's exit from its current monetary policy stance will likely be a cautious one that will first bring market rates closer to the refi rate, then raise the refi rate and eventually review the operational framework of its refi operations.  Over the forecast horizon to December 2010, we are looking for 75bp of refi rate hikes starting in mid-2010 - slightly less than the markets are pricing in.  Overall monetary policy in the euro area will likely remain very expansionary, only a little less so than it is now.

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United States
US Economic and Interest Rate Forecast: Does the Economy Need More Stimulus?
July 09, 2009

By Richard Berner & David Greenlaw | New York

Stimulus Not Needed

The ongoing deterioration in labor market conditions has triggered calls for additional fiscal stimulus.  Certainly, June's decline of 467,000 non-farm payroll jobs, a further decline in the workweek to a record-low 33.0 hours, and a flattening of average hourly earnings point to further weakness in income and factory output.  But while the recession is not over, we believe it will wind down later this summer.  Thus, not only is further stimulus unnecessary, but additional spending or tax cuts could represent a classic pro-cyclical policy mistake.  Indeed, there is a clear risk that any demand-side benefits tied to further fiscal stimulus in today's context would be at least partially neutered by a collateral backup in longer-term interest rates.

Equally, however, there is no need for policy restraint any time soon. We fully expect that the coming recovery will be modest and that inflation will continue to decline for at least the next several months, keeping the Fed on hold until mid-2010.  So while investors may be renewing their focus on downside risks and taking profits from the rallies in risky assets that began in March, we think that the risks for the economy are balanced equally around our baseline scenario.

Unfortunately, employment declines won't end quickly, but there are time-honored signs that job losses have peaked in both initial and continued claims for unemployment insurance and in hiring diffusion indices.  In addition, monthly employment data are inherently more noisy than commonly perceived.  The Bureau of Labor Statistics reports that the typical standard error in monthly non-farm payrolls is 107,000, which, with offsetting errors, means that June's decline is not significantly different from May's.  More fundamentally, we don't think the ongoing employment declines signal more profound economic weakness; rather, they are characteristic of the depths of recession.  For example, in 4Q01, as the recession was ending, non-farm output rose by just 1% annualized, but productivity jumped at a 6% annual rate as businesses slashed hours and payrolls. 

Nonetheless, clients are asking whether the American Recovery and Reinvestment Act of 2009 was too small.  We don't think size is the issue; rather, the problem is one of timeliness and bang for the buck.  It is heavily back-loaded and full of spending that is unlikely to be stimulative.  Moreover, some of the spending programs will be difficult to unwind, leaving structurally larger deficits and debt.  What happened to ‘timely, targeted and temporary'?  The payroll tax cut of US$400 billion that we advocated last fall, if enacted in February, would likely have pushed us out of recession by now. 

Clients are also asking whether the coming recovery could be jobless like the last two.  Reflecting the steep recession, companies have slashed payrolls more aggressively than in any post-war cycle; payrolls are down by 4.1% from a year ago.  We expect only a modest rise in employment next year, in tandem with a mild economic recovery, but a jobless recovery like those of 1991-92 and 2002-03 seems less likely.  Hiring excesses in the latest expansion were minimal compared with earlier periods, and companies have moved more rapidly to slice jobs this time around and are using pay cuts and reduced working hours to cut overall labor costs. 

Modest but Temporary Upside

Indeed, other incoming data and the prospect of temporary factors boosting vehicle sales and output have prompted us to revise our assessment of near-term US economic growth slightly higher than last month.  We now see 2Q declining by 1.5% annualized and 3Q growing by 1%, respectively half a point and a point stronger than in our June forecast.  However, we believe that some of this improvement is borrowing from future quarters.  Accordingly, we have made a half-point downward adjustment (to 1.5%) to our growth estimate for 4Q.

In particular, vehicle sales and production likely will get a boost in the third quarter from the implementation of the ‘cash for clunkers' incentive program.  Following clarification of the rules later this month, we estimate that this modestly funded (US$1 billion) program could add 200,000-250,000 to (non-annualized) unit sales over the August-to-October timeframe.  Although we believe that current assembly schedules are far too ambitious, the OEMs do seem inclined to rebuild inventories this summer.  In all, we estimate that stepped up motor-vehicle output could add more than two percentage points to 3Q09 GDP (see Temporary Upside Risks, but Still a Slow Recovery, June 22, 2009).

Recent data point to a bottoming in some key sectors.  Existing home sales rose 2.4% in May to a 4.77 million unit annual rate.  While this represented a seven-month high, sales have been roughly stable near 12-year lows since end-2008.  Likewise, new home sales have bottomed at about a 340,000 annual rate.  The good news is that inventories have plummeted, so any uptick in sales will further reduce the supply of new unsold homes from May's 10.2 months.  Single-family housing starts are slightly above their lows at a 400,000 annual rate, setting the stage for an eventual bottom in residential construction activity. 

More forward-looking data have shown stability or improvement.  The ISM and other business surveys bottomed in December and the bounce of 26 points in orders and 12 points in the overall index is consistent with an ending of the recession.  Non-defense capital goods orders ex aircraft, which had declined at a 30-50% annual rate during the past six months, are only down 1.5% annualized over the past three months.  Real consumer spending, which was inflated by the liquidation of a major retailer in the first three months of 2009, declined by 0.4% annualized in the three months ended in May, but seems to be stabilizing.  Non-residential construction outlays advanced sharply in the three months ended in May.  Finally, jobless claims have edged lower and the insured unemployment rate appears to have peaked.

Headwinds Persist

However, significant headwinds remain.  Rising mortgage rates and tight credit could abort the housing improvement, as home prices are still falling and foreclosures are rising again following a moratorium earlier this year.  While the rate of decline in home prices is slowing, we think there may be another 10% or so drop in nationwide prices, as measured by the Case-Shiller 20 MSA composite.  Falling wage and salary income, lower home prices, still-tight credit and high energy prices likely will limit consumer spending. Meanwhile, excess capacity, rising commercial vacancies and compressed profitability point to ongoing weakness in capital spending.  Indeed, the recent non-residential construction upturn, especially in the manufacturing category, seems wholly implausible to us.

Not Deflation, Disinflation

Opposing forces should keep underlying inflation tame for now. Aggressive global monetary stimulus is reflationary, has defused the tail risk of deflation, and has helped to lift commodity prices.  A weaker dollar, partly the product of reduced risk-aversion, has also helped to boost dollar-based commodity quotes.  Those factors have helped lift inflation expectations over the past few months.  But persistent slack in the US and global economy should push ‘core' inflation lower over the next year.  To be sure, there is considerable uncertainty over how much slack exists - especially measured in terms of the ‘output gap', or the difference between actual and potential GDP.  But the ongoing increase in the unemployment rate and continued record lows in industrial operating rates suggest that pricing power will be harder, not easier, to come by in the next several months.  On a year-on-year basis, we expect core inflation as measured by the CPI to move down toward 1-1.25% later this year (see The Two Sides of the Inflation Debate, June 15, 2009). 

Monetary Policy: Balancing Risks, Planning the Exit

The near-term risk of lower underlying inflation gives the Fed latitude to maintain accommodation for now.  Having priced in a significant amount of Fed tightening by early 2010 after May's employment data, the reversal in June validated our view that such pricing was too much and too soon.  The FOMC has reiterated that the federal 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 target rate will not occur until mid-2010.  But monetary policy's reflationary thrust is now at work, so unlike those who believe that low inflation and easy money will persist into 2011, we think that tighter monetary policy will be needed in 2010 to prevent inflation from rising too far too fast. 

Does the Fed need to address the back-up in mortgage rates?  Mortgage rates have declined by 25-30bp from their early June peaks, but linger 50bp above their April lows.  If the Fed is concerned that this back-up will abort any housing recovery, officials could alter the composition of its purchase programs - that is, buying more Treasuries and fewer MBS, reflecting the fact that mortgage spreads have tightened to near normal levels.  However, while such a shift is possible at some point down the road, it will probably depend on economic as well as market circumstances.  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, it appears to be taking a wait-and-see approach for now.

Despite apparent extensive discussion internally, the Fed made no mention of an exit strategy from its ultra-accommodative policy stance in its post-FOMC meeting official statement.  Given the need to balance today's accommodative stance with an eventual shift in policy, any substantive communication on this front likely will surface at Chairman Bernanke's upcoming Monetary Policy Report to Congress, scheduled for July 21.

In our view, there are three phases of exit strategy: passive, active and rate hikes.  Some of the Fed's special liquidity facilities introduced in response to the credit crisis will wind down of their own accord - indeed, several are already showing such a pattern. This is what we refer to as a ‘passive' exit.  And the Fed has reinforced these trends by announcing an eventual trimming of the TAF, AMLF and TSLF.

Exit from other programs will require a more active approach.  While we view outright sales of assets 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 repurchase agreements, 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.  Also, the Fed should 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 obtaining congressional approval for an expansion of the interest on reserves program to non-bank institutions or by prohibiting some non-bank entities from participating in the federal funds market. 

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