Is Modern Central Banking Ancient History?
October 21, 2011
By Manoj Pradhan
Two of the three principles of modern central banking were designed for a regime that developed economies will not see for the foreseeable future. The principles - (i) inflation targeting improves growth prospects in the medium run; (ii) inflation targeting effectively means inflation forecast targeting; and (iii) a ‘conservative' central banker (i.e., one who dislikes inflation more than the average economic agent) can deliver lower and less volatile inflation - are almost unquestioned among the central banking orthodoxy. However, these principles were espoused in an era of low debt when monetary policy was the dominant force. In the era we now live in, where debt, deficits and deleveraging (a DDD regime) are the dominant drivers of the economy and policy - an era of so-called ‘fiscal dominance' - the first and the last tenets can cause more harm than good. Inflation targeting and an aggressive approach to taming inflation in such times can create more volatile inflation and higher sovereign risks.
G3 monetary policy is still ultra-expansionary and on its way to becoming even more so, given the current disinflationary risks. However, inflation clocking in at over 5% in the UK and over 3% in the US and euro area gives hawks and dissenters plenty of ammunition. There remains a risk that monetary policy could ignore the perils of trying to curb inflation in an era of fiscal dominance. Tellingly, Chairman Bernanke's speech yesterday, The Effects of the Great Recession on Central Bank Doctrine and Practice, contained not one mention of fiscal concerns, let alone fiscal dominance. That the single greatest peacetime build-up in debt burdens in our lifetimes should go unmentioned in such a speech is strange at the very least.
Fiscal dominance - what does it mean? In the simplest characterisation of fiscal dominance, the fiscal position of the economy effectively ‘sets' a target that monetary policy has to follow. Monetary policy plays a subordinate role, keeps interest rates low and allows inflation to erode the real value of government debt. By contrast, monetary dominance implies that fiscal policy plays a passive role while monetary policy goes about keeping inflation under control without a concern about the adverse effect of higher interest rates on the ability of governments to sustain the debt burden. Such a regime clearly existed before the onset of the Great Recession in the advanced economies (excluding Japan) and continues to exist in the emerging market economies even now. Since the Great Recession, however, things have changed.
Fiscal dominance isn't a new concept. In 1981, one of this year's Nobel Laureates, Thomas Sargent, and co-author Neil Wallace argued that trying to achieve too little inflation in a debt-ridden economy only meant inflation had to be ramped up further down the road to reduce the real debt burden.
More recently, the fiscal theory of the price level has argued that monetary policy needs to accommodate fiscal dominance by providing lower real interest rates as inflation rises. These papers spurred great debate, but the practical contribution of that research is going to be evident only now given that much of the developed world is in the clutches of sovereign risk and there is a prospect of many years of deleveraging of public debt.
Taylor Rules missing the point: Perhaps the best way to highlight the stark contrast between the two regimes is to consider Taylor Rules. Used (and often abused) to assess where policy rates should be, given macro fundamentals, the underlying structure of the Taylor Rule is often ignored. In its construction, the microeconomic foundations of the Taylor Rule assume that the government sets policy in order to keep the budget balanced. This takes an awkward fiscal position of questionable sustainability out of the equation, quite literally.
Why does disinflation perversely lead to more volatile inflation? If we now turn to Taylor Rules under a regime of fiscal dominance, we see that an aggressive pursuit of inflation targeting leads to undesirable volatility of inflation - a point made very convincingly by Kumhof et al (2008). Why? The standard Taylor Rule would recommend, all else equal, that the central bank raises policy rates faster than inflation, thereby raising real interest rates in order to slow down the economy and reduce inflation. However, when there is a high level of indebtedness, higher real interest rates reduce the attractiveness of sovereign debt in two ways. First, the cost of servicing this debt rises. Second, higher real rates reduce output and production, which makes it tougher for economies to ‘grow' their way out of debt. The result is a rise in risk premiums and a higher probability of default.
Eventually, monetary policy is forced to turn its strategy around because it has to ensure fiscal solvency to prevent a catastrophe. In order to do so, it is eventually forced to push up inflation even higher than it was before in order to generate seignorage revenues. Clearly, applying what is considered ‘normal' monetary policy when there is a regime of fiscal dominance therefore risks aggravating not just the fiscal situation but inflation dynamics too.
Allowing the central bank to explicitly respond to fiscal variables improves matters, but the best result comes from eliminating fiscal dominance altogether, through fiscal action.
Lessons from Latin America: The interplay of monetary and fiscal policy under such different ‘regimes' is not a purely theoretical consideration. The history of Latin American economies in dealing with debt issues presents us with an all too familiar experience from the recent past showing the very real concerns that markets and investors should have about the future path of monetary policy. Writing about the Brazilian central bank's desire to pursue its inflation-targeting mandate in 2002-03, Blanchard (2004) proposed that targeting inflation by raising real interest rates in a "high debt, high risk-aversion" environment would have served to make government debt less attractive, leading to an increase in sovereign risk. The ‘correct' solution was a fiscal one, and a credible fiscal reform did indeed resolve the crisis. Echoes of this experience can be found in the economic and market reaction to the ECB's tightening of monetary policy in early 2011. In the wake of the rate hikes, the ability of peripheral countries to service their debt in a higher interest rate environment likely added to the concerns surrounding sovereign risk.
Fiscal policy is the right way to tackle inflation: In both discussions, that of the Taylor Rule and the Latin American experience, the onus of dealing with inflation falls on fiscal and not monetary policy. Meaningful fiscal consolidation, as and when possible, eases out the regime of fiscal dominance, thereby allowing central banks to revert to aggressively dealing with inflation. In the period of transition between a realisation of the need for fiscal consolidation and its achievement, monetary policy serves its inflation-fighting credentials best by not fighting inflation aggressively.
Could central banks already be incorporating fiscal dominance? Given that we are reading tea leaves from the cups of monetary policy statements and actions, it is certainly possible that we may be underestimating the importance that central banks actually assign to fiscal dominance which is not reflected in their official speeches and statements.
In addition, central banks might not actually consider inflation to be a home-grown problem, and hence are willing to tread relatively softly on inflation at this point of time. Considering the Bank of England, domestically generated inflation is very low while imported inflation accounts for the bulk of the UK's inflation problems. Could such an inflation profile also be applicable to the US and the euro area, where growth and pricing power remain weak? If so, central banks may be inclined to pay less attention to inflation, given that the bulk of it comes from outside national borders, while monetary policy would have the greatest impact within the economy.
Finally, central banks may be using the ‘flexible inflation targeting' approach that Chairman Bernanke discussed in his speech yesterday, whereby stabilising output in the near term (particularly under exigent circumstances) is seen to be an important part of stabilising inflation expectations in the medium run. This flexibility could provide central banks the opportunity to assign greater importance to ensuring that growth becomes entrenched rather than worrying about inflation becoming sticky.
Despite these considerations, it appears that central banks are playing down the impact of fiscal dominance. Some within monetary policy committees stand more ready than others to take action to address inflation. The dissenters within the FOMC show that the higher and more persistent-than-expected rise in core inflation is clearly causing discomfort - this despite the fact that the US economy still appears to be short of reaching escape velocity as far as sustainable growth is concerned. The decision by the Bank of England to engage in a further round of quantitative easing just a few days before inflation breached 5% will clearly raise more questions in some quarters. However, the most important ‘revealed preference' of monetary policy-makers to tackle inflation comes from the ECB's decision to raise policy rates in early 2011 despite risks to growth and fiscal sustainability. The resolve of central banks to deal with inflation may now be subdued, but it is far from dormant.
The added complication - the ‘conservative' central banker: Rogoff's seminal paper in 1985 drilled home the result that a person/body with a greater distaste for inflation than the ordinary economic agent could deliver both lower and less variable inflation. This important result was often used to pick ‘conservative' central bankers who would deal with inflation aggressively. It is interesting to note that this line of thinking preceded the advent of inflation targeting but was not abandoned once inflation targeting was widely adopted. The need to preserve the conservative credentials of the central bank was also the rationale for asking for independence from outside influence, including the government. Granting the monetary policy committee, a non-elected body, independence from the preferences of elected representatives does not sit well with the principles of democracy (Blinder, 1993), but the importance of acting decisively against inflation was deemed strong enough to bypass such concerns.
When inflation targeting arrived, the presence of a conservative central banker leading an independent central bank only served to bring inflation down faster. In a regime of monetary dominance, this combination worked very well. Under fiscal dominance, however, it will likely only make an aggressive pursuit of the inflation target more likely and therefore more disruptive.
Is modern central banking history? Some hope from the EM experience: The experience of emerging market economies shows some reason for optimism, but not in the near future. The lessons in indebtedness of the Latin America and the Asian Financial Crisis of the late 1990s were taken very seriously by policy-makers. Under the discipline of a punishing market, EM economies lowered their debt burdens and now boast levels of indebtedness, growth and fiscal solvency that are very attractive compared to the fiscal profile.
Ironically, the fact that EM central banks were not quite as independent as their counterparts in the advanced economies actually helped during periods of fiscal dominance. EM central banks, with their famous preferences for growth relative to inflation, did little to upset the applecart during tenuous times, allowing fiscal policy-makers more legroom to reduce indebtedness. Once the regime of fiscal dominance had been eliminated, EM central banks quickly adopted inflation-targeting policies to further improve macroeconomic fundamentals. Of course, the fact that EM central banks are still only quasi-independent is part of the reason why EM inflation expectations and inflation itself have not moderated even lower.
The one stark difference in the EM experience is that the deleveraging process was carried out against the backdrop of very strong global growth, a luxury that DM economies do not have. Eliminating fiscal dominance may therefore take longer. In this ongoing period of transition, DM central banks may have to take their cue from the EM experience and try to mimic their preference for growth rather than for lower inflation.
Summary: The era of fiscal dominance that we are now living through requires a different strategy of monetary policy. Pursuing traditional inflation targeting aggressively is likely to lead to more, not less volatile inflation. Should it try to reduce inflation, the central bank would have to raise real policy rates, which would end up making sovereign debt unattractive. The subsequent u-turn by the central bank as it tries to stabilise the risk around sovereign debt would require even higher inflation further down the road. The ‘solution' to dealing with higher inflation is therefore better fiscal and not more aggressive monetary policy. Going by the experience of emerging markets, a successful fiscal consolidation wipes out the constraint of fiscal dominance and restores traditional monetary policy and inflation targeting. Until that happens, though, monetary policy can best burnish its inflation-fighting credentials by not fighting inflation aggressively.
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CEE: Trip Notes (October 10-12)
October 21, 2011
By Pasquale Diana
The Morgan Stanley EM Team visited Prague, Budapest and Warsaw last week (October 10-12). We met officials from central banks, IFIs and local economists. This note summarises our key findings. Please call us for more colour.
Czech Republic: The ‘Safe Haven' Koruna Is Myth, Not Reality
Our meetings in the Czech Republic confirmed our impression that there are no serious inflation issues there. At 1.8%Y in September (target: 2%), Czech CPI is running 0.4pp lower than the CNB had predicted in its latest Inflation Report, largely due to softer food prices. Core inflation is also a bit lower than forecast. Excluding administered prices, inflation is just over 1%. Given its successful CPI-fighting record, the CNB clearly has the luxury to ‘look through' next year's upcoming VAT hike, which will temporarily push headline inflation to slightly above 3%.
Meanwhile, domestic demand remains subdued, as credit creation is weak and fiscal tightening continues to subtract from growth. Also, the inventory cycle peaked in 2010, and is clearly less supportive now. Further, the Czech economy remains among the most open in CEE, and the data already show unequivocally that both exports and output have already slowed. Finally, on the domestic side, the recent retail sales releases show slowing consumption.
It thus looks likely to us that both the CNB and analysts will be further revising their growth forecasts downward in the coming months. Currently, the CNB sees growth of just over 2% in both 2011 and 2012, and the next update of the growth and CPI projections will take place in November. It is not out of the question that growth could be seen very close to 1% next year, even lower than our current forecast of 1.5%.
Faced with a benign core CPI and a subdued growth outlook, what can the authorities do? The Min Fin still seems focused on tightening fiscal policy, to the tune of 0.6% of GDP this year and next. And on the monetary side, we feel that at the very least the CNB will continue to signal that no rate hikes will be on the agenda. There has been a clear shift in tone as well as voting at the CNB (the two hawks gave up voting for rate hikes). But what about further monetary stimulus?
With rates at 0.75%, it is quite clear that the room for cuts exists, but is limited. In addition, the central bank could apply moral suasion to persuade the banks to lower the spread between the interbank rate (PRIBOR) and the base rate, currently at around 40bp. However, this would only probably achieve an extra 20bp of rate easing, not much in an environment where credit creation is weak and interest rates are not the reason why this is the case.
This leaves the currency as the most obvious stabilising counter-cyclical force, just like in 2008. And more broadly, the currency dominates the transmission mechanism in such an open economy as the Czech Republic (exports are over 80% of GDP). For instance, the CNB used to count that approximately every 3% move in CZK versus EUR would have the equivalent impact of a 100bp move in interest rates.
The recent resilience of CZK versus its regional peers is puzzling to the CNB. There is widespread scepticism (and we fully agree) towards the notion that the koruna is a ‘safe haven' within CEE. We have argued many times over the years that the Czech economy is a low-beta play within the region: stable inflation, a good fiscal picture, no FX household loans, prudent banks. Yet, the Czech growth cycle is intertwined with the German cycle to such an extent that in case of an external downturn the economy will suffer proportionately more than a country where domestic demand is buoyant (e.g., Poland).
Do not rule out FX intervention to weaken the koruna, if all else fails. In such an environment, the currency ought to act as a stabilising counter-cyclical tool. If it remained very resilient, we think the CNB would try to first talk it weaker, then it may cut rates and commit to rates remaining low for an extended period of time. If that also proved unsuccessful, we think that the bank may even embark on FX intervention (i.e., print CZK and buy EUR), something that it has not done since 2002. Interestingly, we sense that QE - in the form of buying long-dated CZK bonds, for instance - would not be an effective tool to stimulate the economy. We therefore see it as unlikely.
Hungary: Policy Unorthodoxy May Come Back to Haunt Markets
Growth remains challenged, we see clear downside risks to our growth forecast. The view from Budapest is that there is a clear slowdown in the economy, and growth forecasts are being marked down. We see clear downside risks to our meagre GDP forecasts of 1.6% for 2011 and 1.2% for 2012. Were it not for investments in the auto industry, the economy would probably be set to experience a recession in the quarters ahead.
The weaker growth backdrop is forcing the government to tighten the budget further. The government initially expected growth at just over 3% this year and next, but it soon became clear that these expectations would not be met. Therefore, it chose to stick to its fiscal targets (2.5% of GDP deficit in 2012) and implement tax hikes (excise and VAT), running even more pro-cyclical policy. The commitment to meeting the budget targets at any cost is certainly a positive, but even so the growth environment is so weak that we would definitely not rule out further measures in order to cap the 2012 deficit.
Note, for instance, that the central bank, in its analysis of the latest budget trends, sees a deficit outcome of 3.7% of GDP for 2012. Taking into account all the recent government measures, the deficit ratio could ease to 3.4%, therefore still almost 1pp higher than the government target. And these forecasts assume 1.5% GDP growth for 2012, the risks to which appear clearly tilted to the downside. All in all, our impression is that a deficit of around 4% of GDP for next year looks plausible.
Structural reform implementation: some delays, and the growth backdrop makes everything more difficult. As we have argued in the past, the Szell Kalman plan of structural reforms focuses on the right areas (increasing labour force participation, reducing expenditure on disability pensions and reforming public transportation, among others.
The labour market reforms and the changes in local municipalities are on track. The main delays are in the reform of public transportation and disability pensions. The local view is that implementation is running at around 60% of total. And of course, weaker growth provides a less-than-ideal backdrop to introduce sweeping reforms to the welfare state.
Conversion of FX mortgages scheme amounts to a lot of bad publicity, and little else. We analysed the proposed FX conversion scheme in detail in FX Mortgage Plan Raises Deleveraging Risks, September 26, 2011. Our visit to Budapest reinforced our conviction that the conversion rate will be rather modest (10-20% of all loans), as banks are not going to make HUF funding available en masse. The plan seems to have few supporters both in Hungary and abroad, and it looks to be driven by political considerations rather than macro thinking. In short, the plan earned Hungary a lot of negative publicity, and it achieves close to nothing in terms of removing key macro vulnerabilities. Further, it reminds investors of a sometimes unpredictable and centralised policy-making. In light of recent comments from the PM indicating that more help may be in store for FX borrowers, we think that this issue may resurface in unexpected ways in 2012.
NBH: far from a hike, yet still stuck. We came back with even greater conviction that markets overestimate the dangers of a near-term rate increase to protect the currency. Several investors compare the current situation to October 2008, when the NBH last hiked interest rates to support the currency. That said, we think that the central bank sees the situation as very different now compared to then: true, the forint is even weaker, but the banks are stronger, the government bond market is functioning and the NBH has twice as many FX reserves to intervene if it has to.
Of course, this does not mean that the NBH will not hike rates in emergency fashion under any circumstances. But a rate hike seems quite far away, and would only come after a large increase in daily volatility and a steep move in HUF, rather than when a given level of EURHUF is crossed, in our view. The upcoming financial stability report will reveal a new stress test that may shed some light on dangerous levels for the forint and the banking system, but we think that these levels are in general weaker than people assume.
How far are we from rate cuts? The risk environment is clearly too fragile for the NBH to even consider cutting rates at this point. And with a large stock of FX loans and little new credit, it is not even clear why rate cuts would be a major boost to growth. In addition, apart from the risk environment, the inflation outlook for next year does not favour an easier stance: headline inflation will likely hover around 5% for a lot of next year. True, core inflation (ex taxes) is going to be lower, but both the VAT hike and the 18% increase in the minimum wage pose risks of pass-through from headline to core. And, as we have said many times, the NBH has not (yet) established an inflation-fighting track record that allows it the luxury of ‘looking through' one-off price shocks.
It thus seems to us that rate stability is the only plausible scenario ahead. The curve may price rate cuts (as it did a month ago), or some tightening (as it does now), but the bar for a move either way is rather high, given the circumstances.
What about an IMF package? Certainly possible, politics is the main obstacle. We continue to strongly believe that an IMF package, whether as a PCL (Precautionary Credit Line) or a precautionary SBA, would be appropriate, to strengthen Hungary's defences and reassure markets of access to funding and ability to support the currency. That said, there seem to be very high political obstacles to calling the IMF back in, for the moment. Should the situation deteriorate quickly and foreigners decide to sell government bonds (possibly as a consequence of a downgrade to non-investment grade in the coming weeks by one of the agencies), we think the NBH may have to step in and support the bond market. This would clearly be a short-term measure, similar to what the NBH did in 2008. And obviously, given recent action by the ECB and other central banks, the NBH would likely feel less exposed to international criticism for intervening in the secondary bond market. Given how far the monetary policy debate has moved on since 2008, we believe that it would be pretty simple for the NBH to argue that such intervention was made necessary to restore the normal working of the monetary transmission channel.
Poland: A Unique Chance for Reforms
The key takeaway from our trip to Poland was a much more constructive tone on the political environment. The outcome of the recent elections was a resounding victory for PO (Civic Platform), which will likely continue to rule with PSL (Peasant Party), its current coalition partners. Together, PO and PSL will control 235 seats, enough to rule without the support of a third party (absolute majority is 231 MPs). Moreover, the libertarian Palikot party (a splinter PO group) gained 40 seats, a much better performance than expected. Palikot could potentially provide PO with the necessary votes to pass controversial reforms in case PSL did not agree. In short, the outcome was one of continuity, with an option for reform (Palikot).
Given how likely a divided Sejm and a multi-party, ineffective coalition had been ahead of the vote (see "NBP on Hold, Election Fog Thickens", CEEMEA Macro Monitor, October 7, 2011), the outcome was certainly a relief for markets. Moreover, with a sympathetic presidency (Komorowski, PO) and no elections until 2014, the coalition has few excuses for not engaging in reform, other than the difficult macro backdrop. Indeed, we heard several times in Warsaw that this is as good an institutional framework for reform as there has ever been over recent years.
Fiscal situation under control, some slippage possible in 2012. The budget execution for this year looks pretty good, with the January-September cumulative cash deficit at PLN 21.9 billion, and on track to undershoot the annual deficit target of PLN 40.2 billion (2.7% of GDP). In terms of the wider ESA budget, which also includes local governments, the road fund and social security, the government looks on track to meet or even undershoot this year's 5.6% of GDP deficit target.
Next year's 2.9% of GDP deficit target looks harder to meet, primarily because growth is likely to fall well short of the 4% assumed in the latest convergence programme. The Min Fin plans a structural fiscal tightening worth around 2.5pp of GDP in 2012, mostly on the expenditure side. This stands in sharp contrast to the fiscal easing implemented in 2009, which helped to support Polish domestic demand.
Should there be some slippage (to, say, a 4% of GDP deficit instead of 2.9% in 2012), we think that the markets may well forgive Poland, given its reasonable track record on the fiscal front and still low levels of public debt (around 56% of GDP on the ESA measure). But given the Min Fin's determination to hit the deficit target in 2012, we would not be surprised to see more measures (like a further cut in the transfers to OFE, the private pension funds, for instance), especially if they have a minimal impact on growth.
On the debt ceiling, we found broad-based agreement with our calculation that the debt/GDP ratio should remain comfortably below 55% of GDP this year, barring a EUR/PLN breach above 4.70. Among other measures, the fact that from May onwards government institutions were forced to park extra cash at the Min Fin (PLN 23.6 billion) also helped to keep issuance down. On the currency side, the Min Fin continues its policy to convert EUR from the EU transfers on the market, and we estimate that there are approximately €2-3 billion still to come from the EU before year-end. And the Min Fin is sitting on cash reserves worth approximately €5.6 billion (as of end-September).
NBP: no proactive easing in sight. We came away with even stronger conviction that, regardless of how severe the growth slowdown is, the NBP will not be joining the ranks of those EM central banks that proactively take insurance against a deeper downturn and cut interest rates. This is because of three reasons. First, the NBP feels uncomfortable cutting rates as long as headline inflation is hovering just under 4%Y, as some MPC members believe that current CPI also influences CPI expectations and price formation. Second, Governor Belka's prime concern at present is the currency and the stability of the banking system. There is a widespread notion that growth is holding on broadly fine in Poland, and the focus is on preserving the value of the PLN and the stability of the banking system, rather than providing monetary stimulus. Third, we note that in the near term the NBP may well revise up its official CPI projection in November, factoring in the recent depreciation in the zloty (10% on a nominal effective basis). Note that the NBP's estimate of the pass-through is around 20%, which looks a little high perhaps, but can no doubt keep the next CPI projection elevated for longer.
So, a closed door for cuts? No, we still see compelling reasons for rate cuts in 2012. We think that both inflation and growth will ease markedly in early 2012. This will be enough, in our view, to move the NBP's focus away from the PLN and towards providing more monetary policy stimulus in the form of lower rates. After all, this is exactly what happened in 2009. Also, while the downturn is unlikely to be as severe as in the wake of the Lehman crisis, it is also the case that fiscal policy is tightening this time, not easing. So, it is entirely plausible that the NBP feels that it is appropriate to provide stimulus in 2012. We remain comfortable with our view that there will be at least 50bp of rate cuts next year, concentrated in 1H12.
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