In the U.S., much of our recent economic debate has been focused on the fiscal cliff. Even Fed Chairman Bernanke gave a speech on November 20 with a lengthy section about U.S. fiscal policy. While it is without question that the fiscal cliff could have, and probably already has had, dramatic implications for the U.S. economy, central banks around the world should not be neglected in our domestic focus. These foreign central banks face different mandates, political pressures, economic situations and policy constraints, so interpreting them uniformly is impossible, but being aware of their policy steps (both past and future) is crucial to understanding the market.
In recent weeks, two of the most important central banks in the world -- the Bank of Japan (BOJ) and the Bank of England (BOE) -- have both opted not to pursue direct easing measures at this time. Despite prolonged economic stagnation and growing signs that their economy is in a recession, the BOJ opted not to lower interest rates further or institute a quantitative easing program. Due to historical reasons tied to a decade of stagflation, BOJ policymakers are obviously wary of inflation, and seem inclined to tolerate diminished economic growth rather than risk devaluing the currency. However, the BOJ is facing solid odds that next month's election will bring in partisans with a growth-at-any-costs agenda. Since the BOJ has a history of being subjected to political pressure, the move to not ease this month is likely a prelude to a large easing step next month. The only remaining question is whether the BOJ will simply lower interest rates, push interest rates into negative territory, or pursue a form of asset purchases.
On the other hand, while the BOE officially did not pursue further easing when their bond buying program expired at the end of October, they did take steps to reduce British government debt. The BOE announced that they will transfer the income they earn from existing QE investments in the bond market directly back into the British Treasury to help fund the government deficit that has resulted from the financial crisis and recession. To Americans, this should sound familiar because it is what the Fed does with almost all of its investment income. However, over the last couple years, instead of rolling all income (save for operating costs) into the Treasury coffers, the Fed has used much of this capital to reinvest in other easing measures. This is why the combination of Twist and QE3 results in roughly $85 billion/month in asset purchases, not just the $40 billion that is part of QE3. Functionally, the British Treasury funding signals that the BOE is increasingly concerned about British debt and sees diminishing returns to asset purchases, but it should not be forgotten that the BOE still has an ongoing "Funding for Lending" scheme that has shown signs of lending stimulus success in recent months.
While the BOJ and BOE have been extremely transparent in their policy moves over the past few months, the European Central Bank (ECB) and People's Bank of China (PBOC) have been far more opaque. While ECB officials do hold press conferences and public meetings making vague allusions to bailout conditions and possible agreements between struggling states (Greece and Spain) and their creditors (primarily Germany), they continually fail to provide details of negotiations or a credible timeline for resolution of the debt crisis. This communication failure has created market rallies and dramatic losses over the last couple years, and this policy uncertainty has played a particularly profound role in the market decline over the past few weeks. These continued communication failures have prompted some analysts to begin calling for a more open ECB, but what market actors really want is a credible, long-term plan for Europe.
Where Europe lacks in long-term planning, China excels. Chinese growth targets are a great benchmark for investors, but it also creates enormous strain on the PBOC. If growth targets are missed, it diminishes their credibility, so the incentive is to meet targets by any means possible, or to tinker with the numbers. What makes this a particularly uncertain situation is that party politics in China make it unclear when leadership will change at the PBOC and who the next generation of leaders will be. This question of leadership change is crucial to outsiders trying to capitalize on Chinese currency liberalization, so without an indication of who will be the next generation of leadership or how they intend to meet growth targets (stimulating domestic demand or continuing to rely on foreign demand), Chinese monetary policy will remain difficult to predict.
This outlay of recent news and policy stances from four of the world's most important central banks demonstrates just how important central bank transparency is for investors. From what we see coming out of the BOJ, investors should expect the yen to drop in value as policymakers attempt to stimulate the Japanese economy in 2013. Similarly, with the BOE paying down British debt and lending stimulus showing signs of efficacy, investors might well see stronger pound in the new year.
Unfortunately, due to the opacity of their central banks, predicting euro and yuan fluctuations is far more challenging. Some might argue that continued uncertainty, coupled with a fresh downgrade of French debt should drive down the value of the euro, but the markets have largely priced in these problems already. The yuan is even more troubling, since it remains unclear if the new leadership will prioritize gaining immediate legitimacy with short-term economic stimulus that weakens the yuan, or if they will value long-term economic growth through increased currency liberalization that allows the yuan to rise. At this juncture, indications seem to be that the lack of democratic accountability and the weakness of the PBOC in comparison to the Fed mean that stimulus actions in China will be more damaging to international trade relations than beneficial to the domestic economy, so the odds are the PBOC will continue allowing their currency to rise.