Global Economy Watch (GEW) - July 2013

Transcript

Improving economic conditions in the US, coupled with remarks made by Ben Bernanke, the Federal Reserve Chairman, have stoked expectations that monthly $85 billion Quantitative Easing programme could be coming to an end.

Emerging market currencies have been particularly hard hit by this news. The Indian Rupee, for example, hit an all-time low against the dollar in June.

Policymakers across the emerging world have reacted promptly: in Brazil, the government has abolished a tax on foreign bond investments to encourage capital inflows and Indonesia, the central bank has increased its benchmark rate by 25 basis points to support its currency.

So is this the end of cheap money?

Not quite. The Fed has consistently said that interest rates will not be raised if unemployment is above 6.5%, provided inflation remains under control. At its current pace the unemployment target is unlikely to be reached until early 2015; and inflation in the US remains low and stable.  

But it does look like the Fed is at the beginning of a path back towards operating normal monetary policy that could take as long as five years.

Mark Carney is taking over the Governorship of the Bank of England at an interesting time. Based on recent events, the new governor’s priority should be to develop and communicate an exit strategy, or else, he runs the risk of market pressures forcing his hand.

At a glance

Key messages:

  1. Concerns around tapering of QE in the US have hit capital markets, with emerging market currencies particularly affected.
  2. Once monetary tightening in the US begins, it will likely take 3-5 years to return to a ‘normal’ monetary policy environment.
  3. Mark Carney, the new Bank of England governor, should start planning an exit from the current extreme policy settings or risk having his hand forced by external events.
  • Improving economic conditions in the US, and remarks made by Ben Bernanke, the Federal Reserve Chairman, have stoked expectations that the monthly $85bn Quantitative Easing (QE) purchase of assets could be tapered by the end of 2013.
  • Emerging market currencies have been affected by this news, particularly where current account deficits are high (see Figure 1 below). The Indian Rupee, for example, hit an all-time low in June. Policymakers across the emerging world have reacted promptly to their sliding currencies: in Brazil, the government abolished a tax on foreign bond investments to encourage capital inflows, and in Indonesia, the central bank increased its benchmark rate by 25 basis points to support the rupiah.
  • So, is this the end of cheap money? Not quite. In our view, the severe reaction by investors has been unwarranted. A reduction in the pace of asset purchases by the Fed should be evaluated in the context of the nearly $3.5 trillion of assets already held on the Fed’s balance sheet (see Figure 2 below) and its ‘forward guidance’ on the main reserve rate.
  • The Fed has consistently said that interest rates will not rise if unemployment is above 6.5%, provided inflation remains under control. At its current pace the unemployment target is unlikely to be reached until early 2015; and inflation in the US remains low and stable. However it does look like the Fed is at the beginning of a path back toward operating normal monetary policy that could take as long as 5 years.
  • Unlike the Fed, the Bank of England does not have a ‘forward guidance’ policy for interest rates. Mark Carney may be tempted to introduce this policy when he assumes the governorship of the Bank of England. Former MPC member Andrew Sentence suggests that a longer term priority should be developing an appropriate exit strategy from crisis-era policy, or run the risk of external market pressures forcing his hand.

Charts of the month

Figure 1 – Some emerging markets are increasingly depending on foreign portfolio flows to fund their current accounts

Figure 2 – Assets held on the Federal Reserve balance sheet have more than tripled as a percentage of GDP since July 2008