MacroScope

Japan-style deflation in Europe getting harder to dismiss

To most people, the idea of falling prices sounds like a good thing. But it poses serious economic and financial risks – just ask the Japanese, who only now finally have the upper hand in a 20-year battle to drag their economy out of deflation.

That front is shifting westward, to the euro zone.

Deflation tempts consumers to postpone spending and businesses to delay investment because they expect prices to be lower in the future. This slows growth and puts upward pressure on unemployment. It also increases the real debt burden of debtors, from consumers to companies to governments.

In many ways, policymakers fear deflation more than inflation as it’s a more difficult spiral to exit. After all, interest rates can only go as low as zero and if that doesn’t kickstart spending, they’re in trouble. Again, just ask the Japanese.

European leaders and financial markets insist the threat of deflation in the euro zone is low. Outside experts surveyed by the European Central Bank said this week they saw a “very low” probability of deflation. And this is what European Central Bank president Mario Draghi said last week:

“We have to dispense once more with the question: Is there deflation? and the answer is ‘No’.”

A week before emerging-market turmoil, a prescient exchange on just how much the Fed cares

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The last seven days has been a glaring example of fallout from the cross-border carry trade. That’s the sort of trade, well known in currency markets, where investors borrow funds in low-rate countries and invest them in higher-rate ones. Some $4 trillion is estimated to have flooded into emerging markets since the 2008 financial crisis to profit off the ultra accommodate policies of the U.S. Federal Reserve, Bank of Japan, European Central Bank and the Bank of England. Now that central banks in developed economies are looking to reverse course and eventually raise rates, that carry trade is unraveling fast, resulting in the brutal sell-off in emerging markets such as Turkey and Argentina over the last week.

The Fed’s decision on Wednesday to keep cutting its stimulus effectively ignores the turmoil in such developing countries. And while the Fed may well be right not to overreact, it makes one wonder just how much attention major central banks pay to the carry trade and its global effects — and it brings to mind a prescient exchange between some of the brightest lights of western economics, just a week before emerging markets were to run off the rails.

On January 16, minutes before Ben Bernanke took the stage for his last public comments as Fed chairman, the Brookings Institution in Washington held a panel discussion featuring former BoE Deputy Governor Paul Tucker, Harvard University professor Martin Feldstein and San Francisco Fed President John Williams. They were asked about the global effects of U.S. monetary policy:

Forward guidance is not fully living up to its name

Britain’s economy may have seen one of the fastest rebounds among industrialized nations last year, but half of 56 economists polled by Reuters think the Bank of England has lost some credibility over its handling of the forward guidance policy.

The policy – an advance notice that monetary conditions will not be tightened too fast or too soon – was a way of managing market bets, at a time when the scope for stimulating economies through conventional interest rate cuts was limited.  Many say it was a necessary transition from the ultra-loose rate policy of recent years to a more normal post-crisis one. Indeed, the use of verbal intervention to guide monetary policy has been on the rise in recent years, as shown by this graphic on the Federal Reserve. 

But the BoE’s forward guidance has come under a lot of criticism and its results have been mixed, as highlighted by this Reuters story  and FT blog.

The Bank of Canada is probably not ready to seriously consider cutting rates — yet

With all signs showing the Canadian economic miracle is fading, the Bank of Canada is understandably starting to sound more dovish. The Canadian dollar has got a whiff of that, down about 10 percent from where it was this time last year.

But that doesn’t mean Governor Stephen Poloz is ready to signal on Wednesday that his rate shears are about to get hauled out of the shed.

Yes, economic growth is expected to be restrained over the next couple of quarters, the long-awaited pick up in exports and business investment still seems elusive and inflation continues to remain undesirably weak.

ECB rate cut takes markets by surprise – time to crack Draghi’s code


After today’s surprise ECB move it is safe to forget the code words former ECB President Jean-Claude Trichet never grew tired of using – monitoring closely, monitoring very closely, strong vigilance, rate hike. (No real code language ever emerged for rate cuts, probably because there were only a few and that was towards the end of Trichet’s term.)

His successor, Mario Draghi, has a different style, one he showcased already at his very first policy meeting, but no one believed to be the norm: He is pro-active and cuts without warning. Or at least that’s what it seems.

Today’s quarter-percentage point cut took markets and economists by surprise.

The limits of Federal Reserve forward guidance on interest rates

The ‘taper tantrum’ of May and June, as the mid-year spike in interest rates became known, appears to have humbled Federal Reserve officials into having a second look at their convictions about the power of forward guidance on interest rate policy.

Take James Bullard, president of the St. Louis Fed. He acknowledged on Friday that the Fed’s view of the separation between rates guidance and asset purchases had not been fully accepted by financial markets. “This presents challenges for the Committee,” he noted.

A decision to modestly reduce the pace of asset purchases can still leave a very accommodative policy in place to the extent forward guidance remains intact.

Congress “smashed the instrument panel” of U.S. economic data: Fed’s Fisher

Richard Fisher, president of the Dallas Federal Reserve and one of the U.S. central bank’s arch inflation hawks, took us by surprise this week – he told Reuters that, given all the uncertainty generated by the government shutdown, it would not be prudent for the Fed to reduce its bond-buying stimulus this month.

“It is just too tender a moment,” he said. That was on Tuesday, before a last-minute deal averted a debt default but set up additional uncertainty by pushing the statutory spending cap into February.

Fisher said he wishes the Fed had begun the so-called ‘tapering’ process in September as markets has expected. But while he did not rule out a pullback from the current $85 billion monthly pace of asset purchases in December, he did acknowledge the next couple months of data could be “noisy” as economists try to weed out temporary shutdown effects from the broader trend.

Time for Fed to rethink its forward guidance?

Federal Reserve officials have largely acknowledged by now that leading markets to believe the central bank would reduce its bond buying stimulus in September and then failing to do so was a communications blunder.

For Zach Pandl, a former Goldman economist now at Columbia Management, this means the Fed may have to reshape its guidance to financial markets – even if the exact contours of the changes remain unclear.

Last month’s surprise may have increased the odds that the committee will rework its forward guidance in some way (though this will depend importantly on the identity of the next Fed Chair).

Fed doves strike back


Now that Washington’s circus-like government shutdown has put a damper on hopes for stronger U.S. economic growth going into next year, dovish Federal Reserve officials again appear to have the upper hand in the way of policy commentary.

Take Eric Rosengren, the Boston Fed President who had been unusually quiet as the tapering debate gathered steam. In a speech in Vermont on Thursday, he returned to a familiar theme – the central bank still has plenty of firepower and should not be afraid to use it.

Unfortunately, most of the risks to the outlook remain on the downside. Concerns over untimely fiscal austerity here and abroad, and the possibility of problems once again emerging in parts of Europe, could cause the Federal Reserve to miss on both elements of its dual mandate – employment and inflation – through 2016.

How big is the Fed’s communications gap? Six months, give or take

You have to give Federal Reserve Chairman Ben Bernanke credit for standing his ground on data-dependence. Despite widespread suspicions, including on this blog, that the central bank would begin reducing the pace of its bond-buying stimulus in September simply because the markets were expecting it, the Fed chose to hold off in the face of a still-fragile economy.

Here’s how Bernanke addressed the issue of the market’s surprise at the Fed’s decision at his press conference:

I don’t recall stating that we would do any particular  thing in this meeting. What we are going to do is the right thing for the economy. And our assessment of the data since June is that, taken collectively, that it didn’t quite meet the standard of satisfying our – or of ratifying or confirming our basic outlook for, again, increasing growth, improving labor markets, and inflation moving back towards target. We try our best to communicate to markets – we’ll continue to do that – but we can’t let market expectations dictate our policy actions. Our policy actions have to be determined by our best assessment of what’s needed for the economy.