Opinion & Analysis
In recent weeks the European Central Bank Governor Mario Draghi and Federal Reserve Chairman Ben Bernanke respectively outlined debt monetisation programmes.
Each in their own way momentous, these developments in Central Bank policy have far-reaching implications for New Zealanders and may even become the catalyst for a change to the Reserve Bank's inflation policy target.
The Fed's commitment to an open-ended bond purchase programme is the antidote of choice for persistently high unemployment levels which had become of 'grave concern'. The Fed has elevated full employment, previously considered the poor cousin of its dual policy goals, to at least the equivalent of what was previously considered to be its primary role, the maintenance of price stability or low inflation. The rationale being that if zero interest rates are not enough to get the economic bonfire roaring, then pouring an unlimited supply of money on to the embers will eventually do the trick.
Meanwhile, the ECB's hand has been forced by the sheer necessity of providing back-stop liquidity to several precarious sovereign nations in order to fulfil its promise to 'do what it takes' to keep the Euro-area currency bloc intact. Whilst the ECB's plan doesn't guarantee the survival of the Euro, it nonetheless signals that there are now few, if any, sacred policy cows that stand in the way of forestalling the unpleasantaries lurking on the far side of monetary disintegration.
The effect of these programmes will be substantially similar despite the ECB's pledge to sterilise the cash injections with offsetting system withdrawals. Both central banks are printing money and either directly or indirectly providing monetary financing to their respective Governments. The roles of monetary policy, typically the sole responsibility of a modern Central Bank and fiscal policy, the role of governments, are becoming increasingly indistinguishable.
Such initiatives were unthinkable prior to the GFC, however since the crisis of 2007/08, expediency has time and again trumped what was previously anathema. The US and Europe are not alone of course, the UK and Japan continue to carry out their own quantitative easing programmes.
The monetary authorities are attempting to navigate a palatable route on a journey of deleveraging as the credit excesses of several generations are gradually whittled to a more tolerable level. In the US, private sector debt increased from 50 per cent of GDP in 1950 to a peak of over 175 per cent in 2009. Public debt has similarly ballooned. Deleveragings such as we're experiencing now are infrequent and, because of that, there is little in the way of institutional experience of them and knowledge of what to do when they occur.
Happily there is precedent. Unhappily history shows the outcomes are not good for everyone. The Bank of England itself recently acknowledged that quantitative easing unavoidably has distributional implications.
The Fed and the ECB's actions are consistent with those eventually resorted to by monetary authorities during past deleveraging cycles where excessive credit build-ups were dealt with. In short they're attempting to reduce the overall debt to income ratio by 'growing' the economy out of the debt mire and doing so by expanding the money supply and monetising debt. Such an approach is termed reflation whereas the consequences of pursuing deflationary policies (debt defaults and fiscal austerity) would be a catastrophic reduction in economic activity and income whilst causing much of the debt to become worthless. In other words the alternative is a depression.
There were several examples of successful reflationary deleveragings in the 20th century. Japan and the US in the 1930s at first pursued deflationary policies and stumbled their way into the Great Depression. In the US, deflationary policies were abandoned along with the gold standard in 1934 (the USD was devalued by 40 per cent relative to gold), money supply was expanded and the economic recovery commenced soon thereafter. The UK post WWII is also an example worthy of examination.
Key components of these reflations included currency devaluation, expansion of money supply, the maintenance of negative real interests and the stimulation of activity until nominal economic growth exceeded nominal interest rates. Such conditions are positive for economic growth but are usually bad for fixed interest investors. Further, they can persist for much longer than generally understood. The UK's post-war deleveraging spanned fully two decades.
By expanding their money supplies, the reflationist countries are deliberately undermining their currencies in order to improve trade competitiveness and raise inflation expectations. The effect of currency devaluation is to increase the relative cost-effectiveness of key input costs such as labour relative to trading partners thereby improving export competitiveness.
As a result, countries pursuing orthodox monetary policies such as Australia and New Zealand experience upward currency movements. The currencies of such nations also tend to receive an unwelcome boost from global investors seeking a safe-haven for their savings. Such outcomes predictably cause angst amongst their exporters and policy-makers.
Some are now questioning the wisdom of settling an explicit inflation policy target in New Zealand for the incoming Reserve Bank Governor whereas globally central banks are pre-occupied with economic growth. The consequences of this policy framework will be interesting but probably painful to watch. The implications of an appreciating currency for New Zealand are fairly self-evident as they were to the Swiss who became so fed-up with the appreciation of the Swiss Franc that they ended up pegging it to the Euro.
A better idea might be to peg the Reserve Bank's inflation target to the weighted average of our trading partners? Although we would inevitably experience higher inflation we would likely avoid the relative contraction that will probably result from the pursuit of monetary orthodoxy in an unorthodox world.
In any event, monetary policy globally is likely to remain exceptionally easy for an extended period of time. Fixed income investors who have become accustomed to interest rates substantially in excess of the rate of inflation will struggle to find investments that meet their expectations. Unfortunately, such an environment is likely to be the new normal. Central banks' actions signal that it's time for a portfolio re-think.
Simon Botherway is a private investment analyst.
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