The instability in central bank divergence
February 26, 2014
The best place to start this analysis is with the insightful remark made by Martin Wolf back in October 2010. Writing in the Financial Times, Mr Wolf correctly projected that “the US is seeking to impose its will, via the printing press. The US is going to win this war, one way or the other: it will either inflate the rest of the world or force their nominal exchange rates up against the dollar.”
First through quantitative easing 2 and then “Operation Twist” and “QE3”, the US Federal Reserve’s prolonged reliance on unconventional monetary policy confronted country after country with a difficult choice: to either tolerate a significant exchange rate appreciation – thereby risking competitiveness, jobs and, in some cases, domestic financial stability – or follow the Fed in loosening monetary policy.
Nowhere was this dilemma greater in the advanced economies than in Japan, which experienced a sharp currency appreciation in the context of an already prolonged period of inadequate economic growth. The dramatic policy shift that occurred in late 2012 has turned the Bank of Japan into one of the most aggressive users of its balance sheet to boost the economy.
In countering the appreciation of its currency, the BoJ has transitioned to a very expansionary policy stance. Moreover, based on recent signals from Haruhiko Kuroda, its governor, the BoJ may also find that, by the end of this year, it is among the last central banks voluntarily pursuing a hyper-accommodative stance.
Notwithstanding moderating inflation, and having already stopped its QE operations, the Bank of England will likely come under growing pressure during this year to signal a further reduction in policy accommodation; and to do so by changing its “forward guidance” regarding the maintenance of a floor on interest rates. In the process, it will likely be leading western central banks on the “rate normalisation” path starting next year.
For its part, and absent a major economic slump, the Fed will complete its full exit from QE by the end of this year. But, unlike the BoE, it will not be signalling any impending interest rate move in the first part of 2015. Instead, it will likely strengthen its forward guidance by replacing its simple unemployment threshold with more holistic measures of the labour market and a more explicit inflation floor.
The European Central Bank will likely come third in this line-up, led by the BoE at one end and the BoJ at the other. Specifically, it is unlikely to join its American and British counterparts in gradually removing either price or quantity accommodation. Indeed, to do so would strengthen further the single European currency at a time when the eurozone is only modestly existing recession. But it will also resist joining Japan as a massive implementer of QE.
Instead, the ECB is likely to opt for some type of “credit easing” as a means of supporting the flow of credit to rationed companies and individuals – an action that will attract significant media attention but is unlikely to dramatically change economic conditions on the ground.
The prospects for this more varied mix of central bank policies is, at least for now, consistent with underlying trends in real and nominal gross domestic product in each of the economies. But its viability can only be ensured if other components of the overall economic policy stance evolve appropriately in supporting the still-elusive (and much-needed) shift to more sustainable private sector-led growth – starting in the UK where the government is eager to rebalance the economy from consumption and housing to exports and investment.
Absent such comprehensive policy support, and given the unbalanced and still-fragile state of the advanced world’s growth engines, this attempt at central bank policy differentiation could well lead to significant currency realignments and a more general risk of financial market instability. The result of which would likely force central banks into renewed policy convergence, or what Michael Spence, the Nobel Prize-winning economist, once labelled a “non-cooperative co-operative game”.
The writer is the outgoing chief executive and co-chief investment officer of Pimco