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Central Bank Normalization: Coordination Or Ataxia?

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by: Roger Salus
Roger Salus
Macro, portfolio strategy
Summary

Starting in 2017, there emerged widespread talk about "coordination" among the central banks of developed economies.

Even in early 2018, it seemed assured that mutually tighter monetary policy would dominate, almost by design.

As of June, central banks have been giving increasingly mixed signals with regard to their intentions.

This could well indicate that central banks are looking more inward, and their respective policies may be less coordinated, if they ever truly were.

Merely one year ago, there was much ado about coordination among the developed world’s central banks. Many saw a mutual normalization of monetary policy, whether in the form of ending quantitative easing policies, tapering said policies, or raising overnight bank rates. To be sure, with the possible exception of Japan, most observers believed a movement towards tightening was upon us. As it happens, the US Federal Reserve has stuck to its intentions, with new chairman Jerome Powell apparently continuing the slow but steady pace of increases to the funds rate initiated by Janet Yellen.

Early in 2017, the ECB announced it would incrementally reduce bond purchases, and end them completely by September of 2018. Even Japan, by year’s end, had reduced the annual rate of Japanese government bonds it purchased. With the Banks of England and Canada increasing their official and overnight rates coordinated hawkishness seemed self-evident.

Well, dear readers, as we bravely forge into 2018, that coordination appears far less assured. In a matter of a couple of months there have been conflicting signals. The ECB is no longer sure that ending bond purchases in September is a good idea; the Bank of Japan does not feel that tightening is "appropriate" in the near future; meanwhile, the Bank of England is once again open to keeping its official rate low for another two years. At its May 30th meeting, the Bank of Canada held the overnight rate steady, characteristically displaying hawkishness mostly in words.

Back in January, Seeking Alpha contributor, John Hugh Smith surmised that 2018 would see coordinated stimulus "give way to nationalist self-interest in the tightening phase." Whether one agrees with all the conclusions in Mr. Smith’s intriguing article he clearly identified what will be the crucial questions central bank watchers will be asking: Were the monetary policies of developed economies truly coordinated? Or, are they becoming more "nationalistic," to use Mr. Smith’s term?

Let's take a quick look at the most recent words and actions from central bankers.

The Fed: Staying The Course

The one central bank whose actions seem most predictable over the next 12 months is the Federal Reserve. As readers are doubtless aware, the intentions of the Fed to gradually normalize policy have made known since Janet Yellen was chair. Even before officially taking the reins, Jerome Powell was fairly clear in his intention to make "continuity" a part of his chairmanship.

Thus far, Mr. Powell has followed through, overseeing one twenty-five basis point hike to the funds rate since taking the helm in February, and most expect another increase during the upcoming June meeting. In fact, the Fed is widely expected to have instituted a total of four quarter-point hikes by the time Powell’s first year concludes in early 2019.

Already there are stirrings that this familiar narrative may not be as assured as once assumed, but these stirrings are not coming from within the US. With growth rates slowing in developed economies, even going negative in Japan, there has emerged the predictable speculation that Fed tightening may slow in response. Indeed, given the recent turmoil with Italian bond yields some have suggested that June’s expected rate increase is no longer likely for this very reason!

Meanwhile, the rising US dollar has put heavy pressure on some emerging market currencies, like the Turkish lira and the Argentine peso. On May 30, the central bank of Indonesia increased its benchmark rate at an unscheduled meeting. By June 6th, Indonesia's central bank chief joined his Indian counterpart calling on Jerome Powell to "be more mindful of the global repercussions of policy tightening amid a rout in emerging markets."

As compelling as these developments may appear, they do not in your author’s opinion constitute motives which would cause the Fed to stray from its carefully laid plans. Chairman Powell has essentially already advised emerging markets that continuing the Fed's policy direction will not – indeed, cannot – notably alter the economic realities in emerging markets. As for Italy, the argument for it affecting normalization in the US is weak. Thus far, the situation in Italy has not created a widespread financial crisis, and unless it does the Fed will likely regard European banking issues as Europe’s concern.

The most important factors weighing on the Fed will not be European bond yields or EM currencies. The Fed, after all, has a mandate to pursue price stability and promote full employment. Back in March, I wrote a column focusing on what I see as the misplaced role the unemployment rate plays in the Federal Reserve’s policy decisions, but despite your humble author's consternation that key data point's role remains predominant in the Fed's decision-making process.

Thus, the reportedly low unemployment rate will keep the Fed's focus on normalizing the funds rate. Recent stats, moreover, show US consumer spending coming in stronger than expected. Barring a sudden financial crisis, those expecting a surcease in the current normalization path are likely to be disappointed.

The Bank of Japan: "Yes, We Have No Bananas"

Ascertaining the Bank of Japan's intentions is considerably more challenging.

2017 was the year that Japan quietly reduced the number of Japanese government bonds (JGBs) it purchased, from around ¥80 trillion to just under ¥50 trillion. This was achieved under a new mandate whereby the BoJ no longer buys a predetermined number of bonds (¥80 trillion annually) but instead purchases only as many as needed to the keep the 10-year bond at a zero yield. The noticeably smaller number of bonds needed in 2017 to maintain that 0% rate was widely interpreted as a central bank backing away from its radical accommodativeness. Thus the "stealth tapering" policy narrative was born.

Of course, JGBs are only one of the purchases the BoJ makes as a form of monetary stimulus. By January, observers like Wolf Richter were making much noise about the fact that the BoJ had slightly reduced its purchases of Japanese ETFs in the final quarter of 2017. Mr. Richter, as well as countless others, have interpreted this as yet another step on the BoJ's long road to policy normalization. But is it?

In typical BoJ style, just as the experts began talk of stealth tapering in the Japanese ETF market, there came reason to pause. In March the BoJ made a massive increase in its ETF purchases, resulting in a record monthly increase. This increase appears at first glance to be short-lived, as April and May saw the BoJ once again reduce ETF purchases, leaving many an observer befuddled. Adding to the confusion, in the inaugural news conference following his reappointment, Governor Kuroda made a most interesting speech.

He first spoke of the need to normalize and eventually end the easy-money era of his tenure; however, the rest of the speech essentially stressed that doing so was "inappropriate" at this time or at any time in the near future, and in fact even left the door open to further easing should the economy take a downturn.

Clear as mud? Actually, all this is not as contradictory as it may first appear. With all due respect to Wolf Richter and other analysts who are far more knowledgeable than I, there seems to be an overall eagerness to read into the BoJ's actions what isn't really there. "Stealth tapering" is no such thing, and I will explain why.

The BoJ's previously mentioned see-saw-like actions in the ETF market are actually not new. Twice in the last 12 months the central bank made similar massive one-time purchases, only in those case they were in the bond market, as I wrote about here. Now this relates to the new mandate whereby purchases are made according to perceived need rather than by predetermined quantities. With 2017 being a strong year for global growth, and for the Japanese economy, the need to accumulate another ¥80 trillion in JGBs was not there. A 0% 10-year bond was achievable with fewer purchases.

There is another side to this policy coin. Just as the flexible policy allows Mr. Kuroda to taper asset purchases, it also opens the door to further easing, and even allows him to do so unannounced. It will simply depend on whether doing so is perceived as necessary. We have already seen how it will work in the form of the aforementioned massive, short-term interventions.

In 2018, we are seeing less robust growth globally. This appears to have rippled to Japan, which saw negative growth in the first quarter of the year. The fact that the record-high purchase in Japanese ETFs happened at the conclusion of that same quarter should not be taken as a coincidence. If growth continues to stay negative, or even hovers below an annualized 1% rate, then expect more actions from the BoJ. More importantly, 2019 will begin with another increase in the Japanese sales tax.

Those who recall know the last time this happened, the Japanese consumer engaged in an accelerated pre-tax spending spree, but then almost fell off the map once the tax increase was implemented. 2019 will likely be a slow year for the Japanese retail sector.

Most importantly, the 800 lb gorilla in the room is Japan's staggering public debt. As Bloomberg recently pointed out, suppressing the interest rate of the JGB market, of which the BoJ owns over 47%, is crucial for the government's fiscal situation:

It also relieves pressure on the government to achieve its target of stopping the increase in debt, as the BOJ has replaced the market in setting bond yields.

The BoJ's new mandate, rather than signifying "stealth tapering", is actually a means to allow the central bank to take whatever short-term actions it wants without having to make any official announcements. Furthermore, by their own admission the BoJ's governors clearly see normalization only as some abstract principle that will occur long in the future. The bank's actions at best have shown recent tendencies towards an appearance of reducing easy-money, not actually ending it.

The ECB: 'Whatever It Takes' Takes Its Toll

The European Central Bank (ECB) has been arguably the most active among its developed economy peers at least since 2015. Since it began its QE program in March of that year the ECB has added almost €2.5 trillion in assets to its balance sheet. Like the Fed, the ECB has - or at least, had - a plan for tapering. 2017 saw monthly purchases reduced from €80 billion to €60 billion, and in January of 2018 the monthly number was halved. By that time it was assumed the program would conclude in September.

As we approach the halfway mark of 2018 the program's conclusion appears, shall we say, somewhat more elastic. Last year's brisk, and somewhat unexpected, growth rate in the Eurozone does not appear to be carrying over into the current year. By May, ECB officials were publicly floating the notion that the scheduled end of QE in September could be extended at least to December, while reiterating that rates would be kept low "well after" the end of QE. More recently, the volatility in the Italian bond market has only added to the speculation that the ECB's QE program will be extended, possibly into 2019.

As compelling as these arguments are I will make the case that the ECB will actually stick to its schedule and end QE in September. As of this writing, the Italian bond situation remains problematic but has not ignited the kind of contagion seen when the PIIGS crisis reared its head in 2010.

This may be due to markets' confidence that "do whatever it takes" Draghi will save the day, or perhaps because the ECB has developed numerous strategies to effectively deal with crises since 2010. The Eurozone economy, though slowing, does not appear in danger of immediate recession; meanwhile, the inflation rate for the currency area jumped sharply in May to 1.9% from 1.2% in April.

These arguments are pretty standard. However, I will offer one additional reason why I believe the ECB will stick to its schedule. Those who monitor both the central banks and their critics are familiar with a nebulous, ill-defined term known as "credibility." Central bank credibility encapsulates many things to many people, and can include perceptions of political independence, reliability of forward guidance communications, and commitment to stated mandates, like price stability.

With the US Federal Reserve showing every indication that it is committed to its own tightening schedule, I think the ECB will feel the pressure to demonstrate that it, too, possesses the credibility to make the Euro a reserve currency on par with the US dollar, even if that means a standoff with Italy or risking further slowing in growth.

There is one last consideration. There is talk that Bundesbank President, Jens Weidmann, will replace Mario Draghi as the head of the ECB next year. Mr. Weidmann is clearly more hawkish than Mr. Draghi and has expressed his wish to see ECB stimulus end on schedule. It should also be noted that Mr. Weidmann was Germany's most vocal critic of the Bank of Japan when the latter began its own aggressive quantitative easing program in 2013, going so far as to accuse the BoJ of currency manipulation. Given this, it seems even more doubtful that the Draghi ECB will upset its own schedule in anticipation of a change in leadership.

The Commonwealth Cousins: England And Canada

I will devote a few lines to the Bank of England and the Bank of Canada, as their respective currencies round out the top five foreign currency reserves held worldwide.

With both slowing economic growth and decreasing inflation, the Bank of England opted not to raise rates in May. Indeed, many observers believe that the economic situation now demands that rates stay low for possibly another two years. This, at a time when Bank of England Governor, Mark Carney, is promising monetary stimulus in 2019 in the event of a "disorderly Brexit". With its key rate at only 0.5% the BoE has been relatively late to the supposed coordinated tightening party, assuming it ever showed up for real.

In the case of the Bank of England I do believe the arguments against raising the key rate will prevail. Despite Mr. Carney's stated belief that "modest tightening" is still necessary I suspect that he will not follow through with his threat. My reasons for believing this actually take us to the Bank of Canada, which just happens to be Mr. Carney's previous employer. Bear with me.

Like the Bank England, the Bank of Canada is outwardly hawkish about its future intentions regarding monetary policy. So far, to whatever extent the Bank of Canada is tightening it is doing so slowly, very slowly. It was less than one year ago that the BoC raised its overnight rate for the first time in over seven years before instituting two more small increases afterward. Since January there have been no further rate increases. Critics of current bank governor, Stephen Poloz, believe that he can wait no longer to begin normalizing the overnight rate, which is still low at 1.25%. At least two increases are widely expected in 2018.

As with the rest of world, the economy in Canada appears to be slowing somewhat after unexpectedly high growth in 2017. The growth rate is projected to fall to 2% from last year's surprise 3% reading. This alone should not cause the central bank to backtrack on its intentions to normalize, but there are other factors to consider.

While Canadian employment numbers look good on the surface there are concerns. Recently it has been reported that the majority of Canadians do not have permanent full-time jobs. It is not getting better. The latest numbers show Canada shed 31 000 full-time jobs in May, which was only partly offset by an increase in part-time employment.

Currently, Canadians are carrying record amounts of consumer debt. With consumer debt-to-household income levels at roughly 170%, Canadians are actually making their neighbours to the South look frugal by comparison. Any additional increases in interest rates could tip the economy into recession.

These trends have been in place for years, so we can observe the BoC's behaviour during that time. The early years of this decade saw rising debt levels catch the notice of central bankers, who warned Canadians to be prepared for rising rates. Of course, those rate increases not only did not come, but the BoC instead surprised everyone in 2015 by actually cutting rates by 50 basis points (ostensibly in response to falling oil prices).

At the time of the surprise rate cuts the BoC governor was the newly appointed Stephen Poloz, who had replaced none other than Mark Carney who went on to head the Bank of England. Thus, Mr. Carney was at the helm when the BoC failed to follow through with its long-standing threat of rate hikes. Given this history, Mr. Carney's threats of "modest tightening" at the BoE currently ring hollow. Meanwhile, the current BoC governor has shown greater propensity to act on the side of dovishness, especially when the economy stumbles.

Conclusion

Much like the high global growth rates of 2017, the appearance of coordination among the central banks of developed economies was something of a fluke.

In keeping with the aforementioned suppositions of John Hugh Smith, central banking now appears more inward-looking. The US Fed seems hell-bent on following through with at least another three funds rate increases. Japan, on the other hand, despite offering some recent platitudes towards normalization, will almost certainly be forced to return to accommodation within the next 12 months due to poor growth, government debt-servicing pressures, and a consumption tax increase.

The ECB will be under pressure by some interests to extend its QE programs, but will likely feel compelled to stay the course for reasons of "credibility" and continuity. Both the Banks of England and Canada, have recently shown propensities to shy away from tightening, despite what they publicly say. With both economies weakening, do not assume they will follow through with their threats to raise key rates.

Investors should, of course, keep an eye on outliers that may upset the trends I just noted. Obviously, a financial crisis, perhaps stemming from Italy or even emerging markets, would force central bankers to rethink their current plans. Any signs of a large jump in inflationary pressures in the UK or Canada could force their governors to become hawkish in more than just words. Finally, a sudden global economic downturn, perhaps caused by a trade war, could potentially reverse the hawkish positions of the Fed and the ECB. That said, I see these events as outliers, and not likely in the near term

Forget the "coordination" narrative for the foreseeable future. To get a sense of what any central bank is doing look at the domestic economy of said bank.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.