This was going to be the year when the other big central banks joined the Fed in “normalizing” interest rates and reversing the past decade’s QE experiment. Instead, the other central banks blinked and went back to aggressive ease, and the Fed is following them. This is a very big deal.
Let’s consider some before-and-after stories:
In September 2018, the European Central Bank began tightening:
(AP) – The European Central Bank is expected to ratchet back its stimulus efforts again on Thursday as it gingerly phases out extraordinary support for the economy left over from the Great Recession and the euro currency union’s debt crisis.
The bank’s 25-member governing council is expected to cut its monthly bond-purchase stimulus to 15 billion euros ($17.4 billion) a month from 30 billion a month, on the way to ending the purchases at the end of the year.
Reinhard Cluse, chief European economist for UBS, said that after the June meeting “the ECB is now essentially on autopilot.” Cluse said that the ECB can phase out the bond purchases and then decide the exact timing of next year’s first rate increase in the summer or fall.
But before any actual tightening took place, the EU economy slowed and turmoil flared in Italy and France. This week:
(WSWS) – The European Central Bank has reversed its policy of slight monetary tightening and announced a new stimulus package in the face of data which show a sharp downturn in growth in the euro zone. The unanimous decision was taken at the meeting of the ECB’s governing council held in Frankfurt yesterday.
The decision came just three months after the central bank announced it was phasing out its asset purchasing program. The bank indicated it would keep interest rates at historic lows at least until next year and potentially indefinitely and set out a new program to offer cheap loans to euro zone banks.
It also indicated it would continue to reinvest the proceeds of bonds which mature under its €2.6 trillion quantitative easing program for an “extended period of time” with reinvestments amounting to about €20 billion a month.
The decision by the ECB came as a result of what president Mario Draghi characterised as a “substantial” downward revision of growth estimates for the region. He said the new outlook for annual growth in gross domestic product was 1.1 percent for 2019, 1.6 percent for 2020 and 1.5 percent in 2021.
In Japan, which has pioneered both negative interest rates and aggressive central bank asset buying, speculation began in 2018 that the Bank of Japan would start raising rates. From a Nikkei/Asia article:
Speculation that the bank would tinker with monetary policy rose when Kuroda mentioned the concept of the “reversal interest rate” in a speech he gave in Zurich in November.
The “reversal interest rate” refers to the process whereby excessively low interest rates hurt the banking sector, making it harder for banks to act as financial intermediaries. In such a case, the effects of monetary easing could reverse and become contractionary.
Those comments led market participants to speculate that the BOJ was becoming concerned about overly low interest rates, and that it might be leaning toward tightening sooner than expected.
But the BoJ “quelled” that talk in December:
(Nikkei) – Bank of Japan Gov. Haruhiko Kuroda has moved to quell recent market speculation that the central bank will tighten the monetary taps, saying it will continue its monetary easing measures in light of weak inflation.
Kuroda’s remarks came as the BOJ concluded its two-day monetary policy meeting on Thursday, during which it decided to maintain its negative interest rate policy, as well as keeping the yield on 10-year Japanese government bonds near zero, despite Japan’s gross domestic product registering a seventh consecutive quarter of growth in July-September period — the first time in 29 years that an expansion has run so long.
“We won’t decide to raise our interest rates just because the economy is in good shape,” Kuroda said at a news conference in Tokyo the same day. “What is important is for us to continue our monetary easing with persistence, creating an environment where our 2% inflation target can be achieved and maintained in a stable manner.”
The Fed, meanwhile, has been the only central bank actually tightening rather than just discussing it. And until very recently Fed Chair Jerome Powell saw the process continuing. From the Wall Street Journal in October:
Mr. Powell also said he believes the U.S. economy is “a long way from neutral”—referring to the point at which interest rates are neither spurring nor slowing economy growth. It is an important focus for Fed officials, some of whom have argued the central bank should stop raising interest rates once they reach that neutral point.
That didn’t work out either. Stocks fell hard and in the late January Fed meeting Powell took it all back:
(Wall Street Journal) – By Wednesday morning, the chances implied by the futures market of any rate increase over the course of 2019 had shriveled to barely 25% and the odds of a cut were over 5%, according to analysts at Bespoke Investment Group. The famously plain-spoken Mr. Powell left the market with little doubt that the probability of tightening had shifted, noting on Wednesday that “the case for raising rates has weakened.”
But policy rates are only part of the story these days. Since the financial crisis, the Fed has used its balance sheet as a powerful tool, buying bonds to affect the shape of the yield curve. Since late 2016, it had begun to slowly unwind those purchases, most recently at a pace of $50 billion a month—a huge number in almost any other context, but not much compared with what was a $4.4 trillion balance sheet. The Fed’s balance sheet has only shrunk by about 10%.
In what arguably was Mr. Powell’s most significant statement on Wednesday, he struck a dovish tone on this process of “balance-sheet normalization.” The signal was that so-called quantitative tightening would continue for now but end sooner than expected. Moreover, he also raised the possibility that the balance sheet could be “an active tool” in the future if warranted—in other words, more bond purchases if markets or the economy cry out for help. Until recently, Fed officials had been insisting the balance-sheet shrinkage was on autopilot.
What does this mean? Several things, all of them momentous:
• 10 years into an expansion, with unemployment below 5% and officially reported inflation at the central bank target of 2%, the global economy is still too fragile to handle historically normal interest rates. The structural weakness that that implies is absolutely terrifying.
• If central banks can’t normalize monetary policy now, they’ll never be able to. Let that sink in. The old conception of monetary policy is over for the remaining life of the current global financial system.
• Since debt is soaring even in this late stage of the expansion with most people working and paying taxes, the financial headwinds that now prevent rate normalization will continue to strengthen. If 2% inflation is necessary to stave off collapse today, then 3% will be necessary shortly. Then 4% and so on, again, for the remaining life of this financial system.
How much time is left? That’s unknowable of course, but it’s fairly safe to say that this central bank course reversal has ushered in the final chapter.