The next recession, low interest rates, the Fed and ECB's Draghi
The stock of Euro Area government bonds trading at negative yields at the end of November, was valued at more than €1.9tn — or approximately one third of the total market — according to the latest Bank for International Settlements (BIS) quarterly report, published Sunday. On Friday in New York following Thursday's market disappointment with an extension of the monthly purchase of €60bn worth of bonds in the market by six months to March 2017, Mario Draghi, ECB president, made an emphatic statement that the central bank had “the power to act, the determination to act and the commitment to act” to meet its mandate of annual headline inflation of about 2%.
Draghi stressed that “There cannot be any limit to how far we are willing to deploy our instruments, within our mandate, and to achieve our mandate.”
He also discussed the impact of changes in commodity prices, in particular oil, and the risk "if they feed into core inflation."
In February 2013, Euro Area annual inflation fell to 1.8%; it was at 0.8% in December 2013; -0.2% in December 2014, and an estimated 0.1% in November 2015 — it was negative in each month of the first quarter of 2015; 0% in April and slightly positive in the rest of the year to November with the exception of a 0.1% dip in September.
Draghi in his speech at the Economic Club of New York said in respect of the trend in prices of what he called "the consumption basket:" "the risk of deflation in the Euro Area is firmly off the table."
BIS research questions some of the received wisdom on deflation: The costs of deflations: a historical perspective.
On the impact of quantitative easing (QE) or bond buying and related measures, the ECB president said:
According to Eurosystem staff assessments, our measures will add almost 1% to GDP between 2015 and 2017. And we are seeing an effect even on smaller firms that are typically harder for monetary policy to reach. In our most recent survey on smaller firms in the Euro Area, for instance, we saw for the first time since 2009 that the net percentage of small firms registering an improvement in business activity has turned positive, for all size sub-groups. Crucially, our measures are also gradually feeding through into inflation. Inflation would likely have been negative this year were it not for our measures. And according to the staff assessment, in the absence of our measures, it would be at least half of a percentage point lower next year and between 1/4 and 1/3 of a percentage point lower in 2017.
In Japan at the end of October the Bank of Japan (BoJ) pushed back the date when it will meet its 2% inflation target to 2017. In October the core consumer price index, which excludes fresh food, fell 0.1% from a year earlier. It was the third straight fall but the BoJ said lower imported energy prices mask an improving inflation picture. Excluding energy prices and food, prices rose 0.7% on year, down from a 0.9% rise in September.
Japan has had close to zero interest rates for 20 years.
Following Friday's strong US jobs report, the Federal Reserve is expected to raise its policy rate by 0.25% at its policy meeting next week — a rise would be the first since 2006.
Mario Draghi also said in New York: "it is inevitable that unconventional policy settings, ranging from negative interest rates to purchases of a broad range of assets, can have unintended consequences on allocation and distribution."
Last week in a note, Matthew Mish and Stephen Caprio, analysts at UBS, estimated that roughly 35% to 40% of the outstanding US high yield and leveraged loan universe “is at risk.”
That works out at about $1.05tn to $1.2tn “in low quality speculative grade debt outstanding.”
“It is our humble belief that the consensus at the Fed does not fully understand the magnitude of the problems in corporate credit markets and the unintended consequences of their policy actions,” Mish was reported to have said, according to the FT. “The implication is that their actions will be reactive, not proactive — but only time will tell.”
Claudio Borio, chief economist of the Bank for International Settlements, known as the central bank for central banks, commented last Friday on the advance release of the BIS quarterly report:
Even as the Federal Reserve appeared to be approaching lift-off, US 10-year Treasury yields were hovering around 2.2% in late November — a telltale sign of an unusually shallow expected path for the policy rate. Moreover, following clear signals of ECB accommodation, some 2tn, or fully one third, of Euro Area sovereign paper was trading at negative yields — a new peak. Market participants also kept wondering whether the Bank of Japan might ease further. Monetary policy divergence loomed ahead, with potentially significant implications for exchange rates and market adjustments. At the same time, interest rates, current and expected, continued to test the boundaries of the unthinkable day after day — and this despite the matter-of-fact tone of much of the running commentary. Familiarity breeds complacency. Under such extraordinary conditions, it is not surprising that markets remain unusually sensitive to central banks' every word and deed. Just think of the market gyrations following yesterday's ECB decision to ease even further, but to an extent that fell short of market expectations.
“What is perhaps new is that the euro seems to be taking on the attributes of an international funding currency, just like the dollar,” said Hyun Song Shin, BIS’s head of research. “Cross-border bank lending in euros to borrowers outside the Euro Area shows the telltale pattern where a depreciating euro goes hand in hand with greater euro-denominated lending to borrowers outside the Euro Area,” he said.
Andrew Haldane, chief economist at the Bank of England and a member of the Bank’s Monetary Policy Committee, said last June that financial markets expect that in Japan and the Euro Area, official interest rates are only expected to have reached 1.2% and 2.0% respectively ten years hence. "And in the UK and US, they are only expected to have reached 2.5% and 3.4% respectively by 2025." See here:
The next recession
Larry Summers, professor at and past president of Harvard University who was US treasury secretary from 1999 to 2001 and an economic adviser to President Obama from 2009 through 2010, writes today in his monthly column for the Financial Times and Washington Post that he is sceptical about the US capacity to absorb significant increases in real rates over the next few years.
First, the long-term trend of real rates has been down over 20 years. Second, there is a likelihood of substantial inflows of capital into the United States, leading to downward pressure on rates and upward pressure on the dollar. Third, the increases in demand achieved through low rates in recent years have come from pulling demand forward in time, leading to lower levels of demand in the future; for example, lower rates have accelerated purchases of cars and other consumer durables and created apparent increases in wealth as asset prices inflated. Fourth, corporate profit rates are under pressure. Fifth, inflation mismeasurement may be rising, as the share in the economy of hard-to-measure items such as health care rises. If so, apparent neutral real interest rates will decline even if there is no change in properly measured real rates.
US and international experience suggests that once a recovery is mature, the odds that it will end within two years are about half and that it will end in less than three years are over two-thirds. Because normal growth is now below 2% rather than near 3%, as has been the case historically, the risk may even be greater now. While the risk of recession may seem remote given recent growth, it bears emphasizing that since World War II, no postwar recession has been predicted a year in advance by the Fed, the White House or the consensus forecast. Historical experience suggests that when recession comes it is necessary to cut interest rates by more than 300 basis points (3%). I agree with the market that the Fed likely will not be able to raise rates by 100 basis points a year without threatening to undermine the recovery. But even if this were possible, the chances are very high that recession will come before there is room to cut rates by enough to offset it. The knowledge that this is the case must surely reduce confidence and inhibit demand.
Pic on top: Mario Draghi, ECB president, before the start of a press conference, ad ECB headquarters, Frankfurt, 3 Dec, 2015
Gillian Tett and John Authers of the FT discuss a bravura New York performance by Mario Draghi, the ECB president, who promised there was no limit to how far he could expand the bank's balance sheet in the fight against deflation.