A world of competitive easing
Last week the Reserve Bank of New Zealand (RBNZ) signalled more easing to come while the European Central Bank (ECB) reiterated its “readiness, willingness and ability to act”, should it be necessary. Minutes from the latest Reserve Bank of Australia meeting indicated the door is wide open to another rate cut in August. And while the Bank of England left interest rates unchanged at its July meeting, it signalled a cut was likely in August in the post-Brexit wake. This week the Bank of Japan is expected to ease monetary policy further and the US Federal Reserve is expected to hold fire on further interest rate normalisation.
One could easily be forgiven for thinking there was still an element of crisis in the world as central banks have had to find ever more inventive ways of easing monetary policy to try to support demand, close output gaps and generate higher inflation.
The reality is the crisis has mostly passed. Most of the major developed economies are growing around, or close to, their trend rate. Yet inflation remains low, reflecting persistently large output gaps around the world as well as the lingering impact of weaker commodity prices.
Regular readers will recall that we have been concerned for some time about the over-reliance on monetary policy to fix the world’s economic problems. Underlying much of the post-Great Recession environment has been a shortage of demand. That was exacerbated in many countries by fiscal austerity, creating a demand gap that monetary policy has been unable to close.
The dearth of demand has contributed to an environment of competitive monetary easing as central banks have implemented firstly ZIRP (Zero Interest Rate Policy), followed by quantitative easing and more recently NIRP (Negative Interest Rate Policy).
Central banks are increasingly pushing on a string with respect to growth and inflation. Yes, there’s more they can do, but will it make much difference? Furthermore, ever more inventive monetary policy is playing havoc with exchange rates and asset prices.
In New Zealand’s case the RBNZ seems set to cut the official cash rate from its already record low of 2.25%. That’s all about the strength of the exchange rate and despite solid economic growth, rising capacity constraints and a rampant housing market. Futures markets are currently pricing at least two and possibly three 0.25% cuts in the Official Cash Rate following last week’s release of an economic update and the announcement of new LVR restrictions.
The strength of the New Zealand Dollar (and the Australian Dollar for that matter) is mostly a reflection of poor policy decisions offshore, particularly the over-reliance on monetary policy. Monetary policy could never fix all the world’s problems alone. We’ve long argued the appropriate policy mix was monetary, fiscal and structural. The disappointing thing is that the world’s leading politicians tend to agree when they are at various multi-lateral forums (like the G20), but fail to follow through when they get home.
On the fiscal side austerity has failed. Even the IMF has recently started to think that fiscal austerity was counter-productive and simply left monetary policy with a bigger job to do. And as we’ve also said many times, structural reform has been missing in action altogether.
At least “Abenomics” had the right intentions, even if implementation to-date has been disappointing. The good news is the recent landslide victory for Shinzo Abe’s government in the Upper House elections has given the Prime Minister a strong and unequivocal mandate to get on with the job.
This week the Bank of Japan is widely expected to ease monetary policy further via a further cut to already negative interest rates and/or increased purchases of ETFs and corporate debt. However it’s the size of the Japanese government’s upcoming fiscal package, which some estimates put at 6% of GDP, is far more likely to have an impact than anything the BoJ may do. But even then this will only offer a short-term cyclical reprieve rather than deal with Japan’s significant structural issues.
This environment has also had implications for the US Federal Reserve with the Federal Open Market Committee keen to push on with the normalisation of interest rates. Strength in the US dollar index has meant the Committee has only increased interest rates once at the end of 2015 from zero to 0.25%, despite above trend growth and many inflation indicators becoming consistent with 2% inflation. The risk for the Fed is they run out of cycle before interest rates are normal (wherever that may be!).
They appear more than likely (the futures market pointing to 10% chance of a hike) to leave interest rates unchanged this week, though the messaging around future intentions will be watched closely. Two hikes this year still appears possible though the upcoming Presidential election may derail a September move, leaving one hike in December the most likely outcome. That compares with the four hikes the Committee expect to deliver this year only seven months ago.
Here at home cutting interest rates will be required for the RBNZ to demonstrate its commitment to meeting its inflation objective. But this reflects unwelcome strength in the exchange rate that is in turn a reflection of poor policy settings offshore. But cutting interest rates from here is not a risk free strategy.
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