Central Bankers' Weekend at Bernie's! Will the Shanghai's Ceasefire in Currency War hold?

Monetary authorities around the world are busily introducing ineffective policies that they hope would create growth. As a result the state of the global economy increasingly looks like approaching the instant when Wile E Coyote runs off a cliff, but keeps spinning his legs, unaware that an impending hard landing is practically unavoidable.  Actually, the unresponsive world economy can be represented by yet another illustrative allegory, the movie Weekend at Bernie's, where two financial professionals (a metaphor for the central bankers), who have discovered a large insurance fraud scam in their company (a metaphor for Too Big to Fail, QEs, or negative interest rates, etc.), are invited to a party at their boss’s beach house over Labor Day. Only when they get there, they discover that their boss Bernie (the global economy) is dead from what looks like a drug-overdose (the massive $225 trillion of debt, and $600 trillion of toxic assets.)  Instead of doing the right thing the two executives decide it better to pretend he’s still alive so they can keep partying! 

Like the young executives in Weekend at Bernie's central bankers around the world have been increasingly using unconventional policies to prop up the global economy, expecting to convince investors that their policies are working and hoping nobody would notice all the Bernie's vital signs have been extinguished, i.e., the transmission mechanism of monetary policy is shattered . The world’s largest four central banks bought assets worth $1.2 trillion in 2015, similar to the amounts purchased post-Lehman and during the 2013 euro-area crisis, with a very little impact on growth. Meanwhile, they are futilely waiting for cheaper oil impacts come to rescue and give a boost to the world economy.  The fact that growth has not yet accelerated after the collapse of oil prices is blamed on the lag structure of impacts and not on the prevailing global uncertainty about the outlook that has weighed seriously on financial markets.

Negative Interest Rates, and market Volatility 

Both the Bank of Japan and the European Central Bank cut rates further into negative territory this year, and both saw their currencies strengthen. This is largely because markets has started to realize that these prop ups are not able to revitalize the economy. Particularly, when in the words of Governor Carney in his G20 speech in Shanghai

 “Volatility has spilled over into corporate bond markets with US high-yield spreads at levels last seen during the euro-area crisis. The default rate implied by the US high-yield CDX index is more than double its long-run average. And sterling and US dollar investment grade corporate bond spreads are more than 75bp higher over the past year. "

That volatility has not disappeared, it will show up soon with Brexit referendum and in the meanwhile, after the latest Fed’s move, is morphed into more of exchange rate volatility.  

Business Fixed Investment, and Intensive Margin

While, the FOMC statement in March  reported that economic activity has been expanding at a moderate pace despite the global economic and financial developments of recent months, it also noted that business fixed investment and net exports have been soft. Undeniably, the strong US job gains in the absence of strong fixed investment, contrary to Fed’s reading, cannot point to additional strengthening of the labor market. As we have repeatedly argued in the past the strong job gains have been mostly emanating from a greater business focus on intensive margin due to the prevailing uncertainty. An intensive margin implies that instead of investing on latest technology firms hire more labour and utilize their existing equipment capacity more intensely. The substitution of transitory labour intensive tactics ( such as introduction of extra production shifts for part-time workers) instead of committing to irreversible longer-term fixed-capital investment has been the main reason for increased use of contingent employment and weak wage growth.

   

By the mid-March, the experience of five consecutive weekly gain for various stock indexes including the Dow, S&P and Nasdaq created the impression that the recent weakness in markets is over.  Recall that the weakness has been observed since the Fed’s December interest rate rise.  Many market analysts were excited that an estimated loss of more than 6 trillion dollars since early January has been recovered, and  reported that their earlier  concerns about slowing global growth is now waning and the outlook for commodity prices has improved.  Nobody, mentioned any fundamental factors. Some attributed the recovery to a rather sharp rise in oil prices and expectations of higher US growth, despite the global slowdown.

High Debt, Banks' Non-performing Loans, and Shanghai's Accord

Yet these factors pale in significance when viewed against global debt, including the U.S. gross national debt  that according  to some estimates would reach a level of $24 trillion by 2020, or just over 100% of gross domestic product, which can surge to $27 trillion if Mr. Trump’s tax cuts are implemented, assuming, of course, that the global economy withstands the shock to international trade stemming from his anti-trade rhetoric. Similarly European sovereign and private debts are quite high while banks’ non-performing loans are disturbingly rising. These are fundamental factors which would not allow a return to a smooth normal growth path – even if policymakers are content with a slow growth trajectory. Wile E Coyote has now reached the edge of debt and QEs cliff.

Given the urgency of the moment, many of us expected that the G20’s February 25th meeting in Shanghai would come up with some fundamental agreement to rebalance the global economy,   would try to readjust  values of   various currencies by employing some version of Purchasing Power Parity, and would restructure  debts. It was hoped that such policies would rescue the banking sector before a full blown financial crisis set in.    Regrettably, once again the International Monetary Fund (IMF) did come up with an entirely inappropriate policy recommendation and instead of arguing for resolving the global financial imbalances, a restructuring of global debts, and an end to currency wars, argued for a coordinated stimulus program!   Fortunately, it was soundly rebuffed by both Germany and the United States.

Nevertheless, the flurry of erratic monetary policy announcements after the Shanghai meeting has led some to conclude that there must have been a secret Plaza type Accord in Shanghai to adjust exchange rates and create some semblance of truce in the currency wars. However, for that  hypothetical accord to be successful the necessary conditions are transparency and completeness, neither of which exist.  In other words the accord must deal with the astronomical global debt, and must provide a framework for the orderly currency readjustments.    All in all, though, judging from the inconsistency of various monetary policies it appears that a putative Shanghai accord, even if exits, would be ineffective and short lived.

  

This is evident from the ECB’s March 10th policy announcement of an array of new unconventional policies.  Mr. Draghi  cut the three official interest rates;   increased the volume of asset purchases; offered more generous terms on targeted longer-term refinancing operations, and introduced a liquidity facility for banks pegged to the quantity of loans on their balance sheet. Given the ineffectiveness of these measures, the only motive that may be detected  for their introduction is a hope for a further depreciation of euro. However, this tactical move in the current currency wars, backfired, as it has been the case for Japan. Both currencies appreciated instead of depreciating. 

Being oblivious to the longer-term damaging impacts of negative interest rates on the financial sector, and their  distortionary impacts on intertemporal preferences,  ECB  reduced euro area deposit rate further down into the negative zone (from -0.3 to -0.4) per cent.  As the chart below shows, it is hard to believe that this move will have any real impact on growth, or will cause a change in the provision of liquidity. The only impact would be on the expected slope of the yield curve of up to ten-year maturity, which now is expected to remain relatively flat for a longer period, exerting more damage to the already fragile banks’ balance sheet.

A flat yield curve removes the banks’ maturity transformation opportunities.  A bank’s ability of intermediation in the credit market, to transform short-term savings into long-term loans, is critically compromised  by the flat slope of the yield curve.  Thus, banks’ profitability is now seriously impaired. Long term rates are low because markets are anticipating a hard landing is inevitable.

In terms of helping the global economy the US Federal Reserves’ policy action on March 16th was not much different.   Ms. Yellen markedly revised the pace at which her bank expects to lift interest rates, justifying the revision by referring to global worries that could adversely impact America’s recovery. This was despite the fact that core inflation in the US, excluding the deflationary impact of lower oil prices, has now ticked up to 2.3 per cent, which is above target for headline inflation of 2 per cent.  Ms. Yellen has halved the number of rate increases that are expected for 2016 to two 25 basis points moves.

However, given our argument with regard to economy’s greater use of intensive margin, the inflation scenario is now much more complicated.   The use of intensive margin indicates a lower growth of the aggregate potential output, as investment for extensive margin is being delayed or abandoned. This would imply a lower non-accelerating inflationary rate of unemployment (NIRU).  A lower potential growth rate determined by an aggregate short-term cost function would cause inflation rate to pulsate in accordance with the on-off use of contingent factors of production. The impact of these bouts of inflation rate on the expected inflation could become a potent source of stagflation.

It is certainly true that the US is now worryingly more exposed to the global volatility.  The alleged surprise of those that consider the Fed’s mandate is to worry about the US inflation and unemployment, or that did not expect a greater Fed's sensitivity to the worldwide repercussions of US monetary policy decisions, is at best disingenuous. It is hard to believe that Fed is not using a structural model in which some forms of covered or uncovered interest rate parity relationships play an important role in determining the value of the US dollar against other currencies.  In other words, global events would impact the Fed’s policy rate setting via this channel, and then reverberate through the balance of trade. As soon as one uses a structural model with some interest parity conditions the sensitivity to global impacts would be a foregone  conclusion. 

Of course, Fed must be acutely aware that all over the world there are now over $7 trillion worth of bonds with negative yields. In other words both governments and banks are now being paid to borrow from the various central banks in the euro area, Japan, Sweden, Denmark, and Suisse.   This would elevate the already unsustainable   level of global debt. A hard landing is becoming even more devastating and painful, when banks are now more vulnerable, more exposed, and larger.