The Strategist

Why are central banks clinging to super soft economic stimulus packages?

06/20/2017 - 14:26

Another change in investment expectations occurred in the global economy. At the beginning of the year it was believed that the turning point in monetary policy was near - instead of super-soft it would become tough. Expectations did not materialize, primarily because of a slowdown in inflation.
From the point of view of investment expectations in the global economy, the current situation looks as follows. The US Federal Reserve raised the rate by 0.25 percentage points in March and is expected to do it three more times this year, the more so if the Republican Congress approves the plan to reduce taxes in the US. Thus, the policy of low interest rates in the world will cease to be dominant. The ECB will begin to wind down the quantitative easing program (expressed in the simple printing of money to buy securities for € 60 billion each month) by the middle of this year. The Bank of Japan will follow its European colleague: in September of last year it set a benchmark of 0.0% of the yield of 10-year government bonds, which should mean that it will buy fewer of these bonds for newly-issued yen. Only the Bank of China had to keep its monetary policy as soft as it was in 2016.

It was assumed that the ECB would announce the end of the quantitative easing program at a meeting on June 7-8 this year. These expectations have affected the world foreign exchange market. The euro was $ 1.07 on March 29. At the end of the month, players in the world foreign exchange market speculated that the US economy showed very good results. The Fed, which raised the interest rate in March, will raise it again, so the dollar should not be weak.

April 27, and the euro is $ 1.08. At the end of the month, players in the foreign exchange market speculated that the demand for dollars could be helped by the expectation of Trump's budget stimulus plan, as well as a record increase in the rate of US stocks. At the same time, the ECB, given the good condition of the European economy, might begin to tighten its monetary policy and not print the euro on such a scale. This should help the course of a single European currency.

All May, players in the world foreign exchange market argued that the investigation of Trump's relations with Russia could make it difficult to implement a tax reduction program in the United States. And it hurt the dollar. However, Head of the ECB Mario Draghi said that the European economy still needs to be stimulated by printing money. And it harmed the euro.

Initially, it was assumed that the ECB would present a new, improved forecast for the development of the European economy at this meeting, and it would serve as a pretext for curtailing the program of quantitative easing of monetary policy. However, just before the meeting, investment expectations changed. It turned out that the rate of inflation in the euro zone amounted to only 0.9% on an annual basis in April - much lower than 2%, which is the official goal of the ECB. As a result, the ECB lowered the inflation forecast this year from 1.7% to 1.5% and stated that it was not going to curtail the printing program.

Here you can recall the inflation expectations of the beginning of this year. In the first week of the year it became known that there is a sharp acceleration of inflation in the industrial countries. Inflation accelerated from 0.8% per annum to 1.7% in Germany, and it approached 2% per annum in the US in December 2016.

Until now, extremely low inflation or deflation have considered to be the main dangers for the world economy. Especially spectacular situation looked in 2015. In the euro zone as a whole, there was deflation of 0.6% - consumer prices fell in 15 of the 19 countries in this zone, including Germany, Italy and Spain (in Greece, deflation lasted 23 months). In this case, there was a striking contrast with the 1980s, when the average inflation rate was 11% per year in Italy and 20% in Greece.

In the United States, Britain and China in 2015, the price increase was close to zero, and these countries stood on the verge of deflation.

Attention is drawn to the fact that there is a so-called inflation targeting in 46 countries now, when central banks subordinate their monetary policy to achieve a certain planned level. Inflation in 2015 was below this level in 30 of them. The central banks did not even know what to do. It was with the aim of combating deflation that the Bank of Japan and the ECB began to significantly soften their monetary policy, but in Japan this had only a temporary effect, and the ECB's actions had not yielded any results at all.

With inflation of 4% per annum, central banks can make a real bet (that is, a rate adjusted for inflation) well below the zero mark, simply preserving the nominal rate of 0% per annum. It was increasingly difficult to achieve a low nominal rate in the situation of almost complete absence of inflation, although the easing of monetary policy to stimulate economic growth is more urgent than ever. In European countries, the authorities tried to use a negative interest rate to stimulate consumer spending. However, citizens did not want to spend money anyway. As British The Economist pointed out in 2015, "for the central banks of industrial countries, the magic number is a twofold: if prices rise by 2% a year, most buyers can to some extent ignore this slow growth. And this slow inflation is extremely useful: it gives bosses of companies the opportunity to punish negligent employees, because freezing wages means its reduction by 2%, and it also gives an incentive to invest the money earned by the company. More importantly, it gives strong insurance against the fact that at some point the economy will go on to deflation. People's desire to accumulate money by postponing purchases creates aspirations that inevitably arise when prices fall. However, despite the professional mantra of 2%, now this fall on the agenda. "

It should be noted that US companies have savings of $ 2 trillion, and Japanese - $ 2.1 trillion.

Thus, in the economy there would be a significant increase in investment or a significant increase in the income of investors. With low inflation or deflation, owners of companies have only one wish - to continue to save money. In addition, in the conditions of deflation, the income of companies is falling, and the salaries of employees, even negligent, are actually growing.

It should also be noted that from 2007 to 2014, the world economy experienced a significant increase in debt - state, corporate and private. It was particularly turbulent in the euro area - by 55 percentage points from GDP. With a decrease in prices and revenues from the sale of goods and services, the nominal amount of debt does not change in any way, only payment becomes less likely.

The acceleration of inflation in industrial countries at the beginning of this year was obliged to commodity prices. In early 2016, the price of oil was below $ 30 per barrel of Brent, and in early 2017 was more than $ 55. In industrial countries, which are importers of raw materials, this, naturally, affects the prices of goods.

However, there are other factors. In the US, unemployment has fallen to 4.7% of the economically active population and surveys of entrepreneurs show that the most pressing problem is not the increase in profitability, but the search for workers to fill available vacancies. As a result, salaries of existing workers are growing: it increased by 2.9% in the USA in 2016 (the fastest growth since 2009). In Germany, unemployment fell only to 4.1% of the economically active population, and the average salary increases by 2.5% per year. Naturally, the growth of wages in the end leads to an increase in consumer prices. Inflationary expectations play a special role. At the beginning of the year, the expected inflation for five years in the US was 2% (in 2015, expected to minus 2%).

In such conditions, inflation accelerates automatically.

As a result, according to investment bank JPMorgan Chase, inflation in industrial countries this year will add one percentage point to the global nominal GDP, and this will increase the profitability of all corporations, as well as stimulate capital investments. 

Now things are different with inflation. The Fed lowered its estimate of core inflation in 2017 (excluding energy and food prices) to 1.5%.

The Japanese Central Bank does not reduce, but increases the volume of purchases of government bonds due to printed money. According to investment bank Morgan Stanley, which includes interest on short-term loans, interest on bonds and the price of shares in the world, monetary policy does not become tougher, but softens. In the end, following the June ECB meeting, the bank issued a statement that European economic growth still needs help - at the expense of printed money. And it turned out that investors had already changed their expectations by the middle of the year: in 2017, there will be no refusal of a super-soft monetary policy. And a change in expectations will affect everything, from stock prices and exchange rates to world oil prices.