A Gordian knot of risks?
We see three key areas of potential risk in 2016 that are woven together.
We see three key areas of potential risk in 2016 that are woven together:
This article will describe the background to the current situation and consider our views on each of the risks that we face and how they interact.
The risks of falling inflation (prices increasing at a slower pace) and reduced liquidity (insufficient demand for a given investment) combine to present a Gordian knot that the central banks have to unravel. To understand the challenge one needs to understand the contributing elements, so let’s begin with inflation.
A healthy rate of inflation is generally perceived to be around 2% a year. This helps to provide a stable environment in which to save (you know roughly what your money will earn), to spend (you know roughly what your money will buy) and to invest (you can anticipate approximate returns (N.B. returns are not guaranteed)).
In contrast, falling prices or “deflation” provide a disincentive to spend or invest. For example, you might be inclined to delay buying a new fridge, car or pair of trousers because in a month’s time that item is likely to be cheaper. Falling prices also could leave businesses less likely to invest and more likely to reduce output until prices stabilise or start to
rise again. Furthermore, employers could be disinclined or unable to increase wages because spending power would increase due to the falling prices of goods and services; each £1 in your pocket would buy more. Falling prices could lead to or be brought about by stuttering wage growth.
If inflation starts to get too high (the rate at which prices increase becomes too fast), central banks can “tighten” monetary policy by increasing interest rates which makes borrowing more expensive and saving more lucrative. This tends to reduce spending and, therefore, with less demand for goods and services there is downward pressure on prices and lower demand for wage increases.
It is more difficult for central banks to encourage an increase in inflation. During the recession of the early 1990s there was scope to “loosen” monetary policy: interest rates were relatively high back then, and could be reduced so as to encourage spending and borrowing. Today, interest rates are at record lows of near-zero across the world. Some interest rates, such as in Japan, some Nordic countries and the eurozone, are negative; that is, the depositor is charged an interest rate to place money with the central bank. So the option of reducing interest rates has been all but exhausted as sooner or later, depositors will hold cash which will at least retain its nominal value.
Therefore central banks have to find an alternative method to loosen monetary policy and some have adopted “quantitative easing” or QE (i.e. printing money electronically). The theory is that with more money circulating in the economy but the same number of goods and services, prices will be pushed up. As prices go up, wage demands are likely to increase creating a cycle of inflation: prices go up, people demand higher wages, people have more money to spend and are in a better position to borrow, there’s more money chasing the goods and services which pushes the prices up, and so on.
In practice, QE has had limited success. The first problem is that much of the quantitative easing was generated by the central banks buying government bonds from large financial institutions. This put more cash in the hands of those financial institutions, but they used much of the money to shore up their finances after the financial crisis instead of passing it on to the man-on-the-street.
Secondly, once the banks’ finances were in better shape, QE provided them with money that they put into the economy by lending it. But after the credit crunch, people and businesses wanted to reduce their debts not increase them. So the demand for borrowing had fallen away, reducing the desired effect of QE. Inflation remained stubbornly low with rates in Japan, the US and the eurozone all trundling along at well below 1%.
With the diminishing power of central banks to increase inflation, the need for wage growth becomes increasingly acute. This is why Japan’s Economy Minister, Akiro Amari, used January’s World Economic Forum to urge Japanese companies to raise wages. Japanese companies are sitting on large cash reserves and generating record profits, but the money is not being pushed into the economy to help generate much needed inflation.
In America, wage growth has been fluctuating between 2% and 5% since the financial crisis but this is largely due to productivity levels having plummeted. The chart above shows that if labour productivity growth had remained at precrisis levels, US unemployment would be five percentage points higher than it was at the end of 2015 – equating to the US economy needing 8 million fewer workers to produce the same level of real gross domestic product (GDP). This would translate into a headline unemployment rate of around 10%. So the “spare capacity” (i.e. ability for the economy to grow without generating uncontrollable inflation) would appear to offer plenty of scope for wage increases before an interest rate rise would be needed.
Even if the looser monetary policy did engender wage growth, one could argue that that would be a good thing as it would encourage inflation and, thereby, encourage spending and economic growth. Should inflation make the leap from the current near-zero levels to beyond the central bank targets of around 2%, then central banks would have plenty of scope to put the brakes on by increasing interest rates.
So was the US Federal Reserve (the Fed) right to raise the key interest rate in December 2015 by 0.25%? The reasons for the increase included communicating a vote of confidence in the US economy and preventing inflation or wage growth getting out of hand and having to increase rates too quickly later on. There is also the historical context of when Alan Greenspan, who was chair of the Fed from 1987 to 2006, failed to increase interest rates and deflate a bubbling economy and housing market that led to the 2007-2009 crisis. In the current economic environment, notwithstanding the substantial fall in the early part of 2016, asset prices have been pushed higher by quantitative
easing, and there are some signs of a potential house price bubble.
However, currently inflation is remaining persistently below the bank’s targets as a result of factors including low oil prices and the slowing of Chinese economic growth. What’s more, the Chinese authorities are having to spend billions of dollars to maintain the relative value of their currency, the yuan, which is intended to stem the outflow of capital from the country. But supporting the yuan in this way also prevents the sending of a shock-wave of deflationary pressure across the global economy, as was experienced in August 2015 when the yuan was devalued unexpectedly.
Paul Volcker, who chaired the Fed from 1979 to 1987, was unpopular for maintaining high interest rates in the 1980s. In retrospect, his actions appear to be justified. Alan Greenspan was loved for keeping interest rates low in the years preceding the crisis, but even he has admitted to having been wrong. Current chair of the Fed Janet Yellen is now left with the poisoned chalice of steering interest rates in the right direction to encourage growth at sustainable levels.
However, the beginning of 2016 provided a difficult combination of tumbling share prices, global economic weakness and poor communication by the Chinese authorities. These developments have led Mark Carney, Governor of the Bank of England, to indicate that he might not increase the key UK interest rate until 2017 or beyond.
Meanwhile, Carney’s equivalents at the European Central Bank and the Bank of Japan have adopted the mantra of “doing whatever it takes” to loosen policy and increase inflation. These factors have already combined to increase the relative value of the dollar, making US exports more expensive to overseas buyers. This puts pressure on US economic growth which is on a downward trajectory; since its high of 3.9% in Q2 2015, it dropped to 2.0% and 0.7% in the third and fourth quarters1.
But there’s another problem; liquidity is showing signs of drying up. The increased demand for government bonds from QE pushed bond prices up and, therefore, yields down. This drove investors to take on higher risk investments in order to maintain yields. Hence the demand for corporate bonds and equities increased, pushing their prices up. So one of the main effects of QE has been to distort the prices of bonds and shares such that the reward for taking more risk has been reduced.
The process of QE made central banks the biggest buyers of government bonds. In the meantime, increased regulation reduced the ability and willingness of commercial institutions to buy government bonds. As the central banks in the US and UK have withdrawn from QE, the biggest customer in the relevant bond markets (i.e. the biggest provider of liquidity) has gone.
If the European Central Bank and the Bank of Japan withdraw from QE, then this will also detract from demand for government bonds. This will push the yields back up which will attract investors away from riskier opportunities such as equities and corporate bonds. The higher the level of risk, the lower the demand.
This paucity of liquidity among the riskiest of bonds (i.e. high yield bonds) has been exacerbated in the first few weeks of 2016 as an overriding sentiment of “risk-off” has taken hold. Investors are moving capital towards lower risk investments due to a number of concerns:
The lack of liquidity means that an investor wanting to sell might have to accept a lower price, or face having to wait until a buyer can be found at a preferred price. Either way there is a greater risk of losing capital value.
It also means that fewer investment opportunities are available because bonds, especially those with higher risk profiles, won’t be issued. This has already proved to be the case with no new issues for nearly three weeks over the December-January period.
So, we are now in a situation where the markets are looking to central banks to make the right decisions for interest rate management, reserve requirements (how much cash banks have to hold back instead of lending) and quantitative easing.
The Fed’s interest rate increase was initially welcomed in the markets, but any gains were lost within a few days, and the market turbulence has called into question whether the interest rate rise was premature. Meanwhile, the Bank of Japan’s reduction of a key interest rate to below zero triggered worries that lower interest rates eroded bank shares and their ability to maintain debt payments on bonds. This led to worldwide nervousness among investors and triggered the fall in finance-related shares mentioned above.
Rather than adjusting interest rates, central banks could adjust the reserve requirement ratios (the amount of registered deposits banks have to keep as cash at hand). The lower the ratio the more that banks can lend. But, as we’ve seen, the appetite for borrowing has fallen, and banks’ profits are under pressure from falling interest rates. So this option might cause a different set of problems.
Quantitative easing could be ratcheted up. The Governor of the European Central Bank, Mario Draghi, has stated that it has worked in the eurozone, and he and his Japanese counterpart keep repeating the mantra of doing “whatever it takes”. The trouble is, QE devalues the currency to which it applies, and devaluation acts as a way of exporting inflation. What’s more, government bond yields are already very low and the illiquidity mentioned above shows that demand for corporate bonds is also low, so more, or a broader range of purchases through QE might not have much effect.
The Chinese are already spending billions of dollars of their foreign currency reserves propping up the value of the yuan, but they can only do this for so long. If other countries chip in with further devaluation, then everyone could end up with further deflationary pressures and lower growth.
So maybe something more radical is needed. In his 4th February article in the Financial Times, Martin Wolf expressed a preference for “helicopter money” i.e. money that is dropped straight into the pockets of consumers either through hand-outs or tax cuts; alternatively, it could involve direct investment in infrastructure projects. This is a fairly extreme measure the outcome of which is uncertain, but then the outlook at the moment is uncertain.
In its weekly report of 5th February, BCA Research mooted the idea of “debt monetization”. This could work as follows:
The initial ¥1 million would be new money in the economy that, in theory would be circulated in the economy. Some of this would be placed into a bank account and that could be used to lend against creating more new money in the economy. This process is known as the “multiplier”.
As well as this actual inflation, there would also be the expectation of inflation from such a policy which would further push prices up in anticipation; if you know that prices are going to go up, you’re more likely to push for a pay rise.
It’s an extreme measure that led to hyper inflation in Zimbabwe and the Weimar Republic but, unlike those two historic examples, Japan is able to pay negative interest rates and has a low level of tax which would make the money multiplier more effective. With the Swedish Riksbank recently having increased its negative interest payments policy, such an approach is no longer unthinkable.
To quote Janet Yellen at her testimony to Congress on Wednesday 10th February, “monetary policy is not on a preset course.” To put it another way, the central banks are going to have to be a great deal more nimble in their actions and careful with their words than they have been for many years.
1 TradingEconomics.Com, US Bureau of Economic Analysis February 2016.
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Any views expressed are our in house views as at 26 February 2016. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions.
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