Global Overview - The battle for independence
Now that most of the advanced economy central banks are scaling back their emergency settings it has become routine to say that global monetary policy has reached an inflection point. But the same could be said for central banking more generally. Before the decade is out, the world’s five most important central banks – the Fed, the PBOC, the ECB, the BoJ and the Bank of England – are all likely to have new leaders. It is an understatement to say that there is a lot riding on the outcome. In most cases, those new leaders will not have been at the central banks they lead when the global financial crisis hit nor have been the architects of the unconventional policy responses that they will be tasked with phasing out. Some of them may even be outspoken critics of the regimes that are currently in place, raising questions about whether the responses to the next global downturn will be as forceful. A hypothetical John Taylor-led Fed or a Jens Weidmann-led ECB may only tighten policy modestly more quickly than Janet Yellen or Mario Draghi would have. However, if either prove more reluctant to reignite QE when the time comes, the next downturn could be deeper and the recovery even shallower.
How central banks interpret the mandates and apply the tools prescribed by legislation are not the only things at stake. We cannot remember a time since operational independence became commonplace when monetary policy was more politicised. To some extent the financial crisis and its fallout made this inevitable; whether due to the perception that monetary policy mistakes contributed to the crisis, concerns that the line with fiscal policy has become too blurred, or the gap between the post-crisis return on financial assets and the performance of the economy (see Chart 1). In a democracy, politicians have a legitimate role to play in setting the goals for central banks and ensuring they are accountable for reaching them, especially as they venture beyond their traditional toolkits. But as students of the 70s and 80s can attest, meddling in the day-to-day decisions of central banks is unlikely to lead to better outcomes. Unfortunately, that ‘truth’ may not be enough in our politically charged times. The next generation of central bankers will therefore need to be savvier if they are to keep their hard-won independence.
US - Why the Fed chair matters
Speculation is building that President Trump will announce his nominee for chair of the Federal Reserve (Fed) within the next week. As of today, betting markets imply that only four people are in the running. The overwhelming favourite is Jerome Powell, a Republican former investment banker and Treasury official who has been a member of the Board of Governors since 2012. The distant second favourite is John Taylor, also a Republican, and a professor of economics at Stanford University whom Ben Bernanke once described as having had a “profound’ influence on the theory and practice of monetary policy. Janet Yellen, the incumbent, but a Democrat, is in third place, while Kevin Warsh, a former investment banker who served on the Fed board from 2006 to 2011 and has been a public critic of the current regime, is trailing even further behind.
How might new leadership impact the Fed? The best prisms through which to consider the implications of a Powell-led Fed are his voting record and speeches. Both are suggestive of someone likely to maintain the broad status quo. In that time he has never voted against a policy decision, including the critical decisions to implement QE3 in September 2012, to raise the fed funds rate for the first time since the crisis in December 2015 and to begin shrinking the balance sheet last month. Powell has been an infrequent speaker, preferring more specialised topics. However, when he has referred to monetary policy, he emerges as a believer in very gradual interest rate and balance sheet normalisation, and a supporter of modest winding back of the post-crisis regulations on systemically important banks. In short, we doubt that a Powell-led Fed would withdraw policy support much faster than the current pace and also think that he would reignite QE should the circumstances require it.
A Taylor-led Fed has the potential to deviate more from the status quo. Taylor’s main academic contribution has been to argue for the benefits of setting monetary policy according to transparent ‘rules’. Today, most central banks use variants of the so-called ‘Taylor Rule’ – in which policy rates optimally change with a time varying neutral real interest rate, the deviation of unemployment (or output) from its natural rate (potential), and the deviation of inflation from the central bank’s target – as one input into their decisions. Despite this institutionalisation of Taylor’s insights, he has been a very public critic of the Fed over the past decade. That is because he thinks that for much of the period since 2003 officials have kept policy too loose (see Charts 2 and 3) and that the use of quantitative easing was too discretionary. In the aftermath of the crisis, he argued that these policy ‘mistakes’ would shortly lead to excess inflation. In the wake of the failure of his inflation predictions, he has focused his critique on the negative implications for financial stability. Taylor’s views may not change the short-term trajectory of Fed policy given he has been a supporter of the predictable withdrawal of balance sheet support. But in the longer-term, policy could be conducted quite differently, with the Fed more reluctant to cut rates to the lower bound or reignite QE, keener to withdraw policy support once a recovery is underway, as well as less likely to apply judgement to changing circumstances. Taylor thinks this will increase macroeconomic and financial stability. If nominated, we think he could be in for a rude shock.
UK - R.E.S.P.E.C.T
Mark Carney may be forgiven for feeling unfairly treated since becoming the governor of the Bank of England (BoE). His early forays into forward guidance proved difficult, and a promise not to raise rates until unemployment fell below 7% now sticks out as a miscalibration. There have also been accusations that he has misled markets, particularly in a Mansion House speech, which hinted at a rate hike that never materialised. However, political events have created the biggest headaches. First was the Scottish independence referendum, during which Carney earned the ire of nationalists by warning that a currency union was not viable. Worse was to come. Carney’s warnings around the short- and longer-term impact of Brexit have been met with fury from EU sceptics and he was recently branded “the enemy of Brexit” by a Conservative backbencher.
Carney is unlikely to lose much sleep over these labels. However, there is a risk that these attacks damage the independence of the Bank, particularly if they come from more high-profile policymakers. Last year, Prime Minister May complained about the “bad side effects” of low interest rates and quantitative easing and warned that “a change has got to come”. May attempted to row back on these comments after the speech, and soon after offered Carney a second term as governor. Nevertheless, these interventions raise challenges, particularly in an era of declining public trust in institutions, a broader and more controversial central bank toolkit, and wider remits including financial policy. It is important for the Bank to make independent assessments of events like Brexit, and communicate these clearly so that households and business understand the BoE’s reaction function. It is even more important if these shocks materialise that the central bank can deliver the policy response it deems appropriate to meet its mandate. Its judgement will not always be right, and policy mistakes happen. However, if politics affects decision making, the credibility of the institution and its inflation target will be undermined.
Has the pressure put on the Bank through the Brexit process changed its behaviour? The large and proactive easing package delivered a month after the vote would suggest not. However, digging into BoE communication since, there is some sense that it may have looked to shield itself from criticism. Having been wrong on the initial short-term impact of Brexit (similar to most observers), the Bank revised its 2017 growth expectations significantly higher to 2%, potentially to avoid claims that it was being alarmist about the fallout (see Chart 4). This always looked sanguine and the Bank has been forced to revise lower since. These revisions may have contributed to the difficulties the Bank has had in persuading markets it has become serious about starting to tighten policy (see Chart 5), even as the supply-side disappointed. If we are right that the Bank’s forecasts and signals have been affected in this way, it provides a worrying sign, but does not represent chronic damage. A hike is now priced in and looks set to be delivered this week. However, if the recent trend towards political attacks on the central bank continues, then the risk of more damaging policy distortions will increase. Carney won’t be around for this, having only agreed to extend his term until 2019. His successor may need to have even thicker skin.
Europe - Doves rule but who steers beyond 19?
Last week saw the ECB announce the extension of its Asset Purchase Programme from January at a lower run rate of €30bn per month (currently €60bn) until September 2018 “or beyond, if necessary” (see Chart 6). The reduction in the pace of purchases comes as little surprise given the robust economic recovery in the Eurozone – particularly this year – and recent signalling from the Governing Council. The strength of the Eurozone recovery is well established at this point, with Draghi highlighting once again the role that monetary policy has played in supporting the upswing in domestic demand and business investment (see Chart 7). He noted that risks to the outlook were balanced, with potential downside risks from global factors and developments in foreign exchange markets counterbalanced by the upside risks to their forecasts from the strong cyclical momentum at present. However, while Draghi was upbeat on the strength of the recovery, he warned that it is not yet self-sustaining or generating a sustained rise in inflation, re-emphasising that patience, persistence and prudence are still needed.
Draghi put a dovish spin on the step down in purchases, refusing to call the process a taper, opting for the term “recalibration”. Additionally, when asked about whether the Governing Council would consider altering the path for policy in the case of an upside surprise, Draghi refused to even address such a scenario. This open-ended approach will give the Council some breathing space out to the middle of next year, allowing them time to assess how the recovery is progressing and, importantly, space to extend if necessary. The successful agreement and communication of extension also illustrates Draghi’s success so far in walking a delicate tightrope. He has managed to again build a consensus on the Governing Council against a backdrop of often dissenting voices, calibrated the pace of purchases skillfully to avoid any acute issues with asset scarcity and maintained an accommodative policy environment, which continues to underpin the recovery.
However, internal dissent and technical constraints are not Draghi’s only problems. The ECB’s position within the Eurozone structure is officially politically independent but in reality the lines are more blurred. The financial crisis further muddied the waters by increasing the pressure on the ECB to adopt ultra-loose and unconventional policies, while the ECB’s still inactivated outright monetary transactions programme led to court claims that it had overstepped its remit. The institutional influence of politics will be clear in 2019 when the European Council appoints Draghi’s successor from a collection of nominees endorsed by EU finance ministers and European parliamentary scrutiny. Speculation is rife about which country will win the political jostling match. Jens Weidmann, Bundesbank president and ardent critic of QE, or a like-minded ‘core’ official such as the Dutch central banker Klaus Knot, are among the most frequently cited names, implying a very real risk of policy taking a more hawkish turn when Draghi leaves. The mistakes of the Trichet-led ECB contrast with the successes of the Draghi era and illustrate the importance of good leadership in a world where monetary policy is the still the major game in town. In extremis, the ECB nomination process risks getting caught up in political horse-trading, undermining the credibility of the Bank and its policies.
Japan and Developed Asia - Who's next?
With Abe recently renewing his democratic mandate in emphatic style, thoughts have quickly turned to the decision on the new BoJ governor. The overwhelming favourite for the position is incumbent Haruhiko Kuroda, with a recent QUICK FX survey seeing 55% of respondents plucking for Kuroda, 18% for Deputy Governor Hiroshi Nakaso, and 11% for BOJ’s Executive Director Masayoshi Amamiya. We suspect the market reaction to the appointment will be binary – based simply on whether the candidate is perceived as an YCC ‘exit governor’ or not. All of those named above are perceived as continuity candidates, who strongly endorse the current QQE with YCC framework. The fact that they account for 84% of responses, suggests that the risks of a more disruptive ‘exit candidate’ are low. However, is the market being complacent?
In recent years, Abe has surrounded himself with reflationist advisors who have been calling for a more aggressive approach. Both influential advisers Etsuro Honda and Nobuyuki Nakahara have called for a change at the BoJ, arguing more imaginative efforts are needed to achieve the 2% target. Furthermore, with board member Goushi Kataoka arguing for more powerful easing measures, the reflationists have an insider in open revolt. Unfortunately, we think the reflationists are likely to face strong political constraints. Firstly, aggressive easing policies that have weakened the yen have proven highly unpopular, as higher import prices have served to weaken consumers’ purchasing power. Secondly, the ruling LDP has pushed back against the prospect of ‘helicopter money’. The party’s constitutional amendments proposal includes adding language to increase fiscal responsibility, while a VAT hike was a key campaign promise. A more palatable reflationist candidate might be Takatoshi Itoh. He has advocated the adoption of a price-level target, which forces policy to respond to past misses. This framework would clearly be incompatible with the recent trend for the Bank to downgrade its inflation outlook without altering policy settings (see Chart 8). For that reason, Itoh is likely to be perceived as an YCC ‘exit’ candidate, even if his approach is instinctively more dovish.
As for a more hawkish shift, even a long list fails to throw up a candidate wanting to follow other central banks into tapering. That is understandable given underlying inflation remains close to zero, while prices most sensitive to labour costs have been falling (see Chart 9). That said, there is plenty of discontent with the pre-eminence of core-CPI as a measure of progress in the battle against deflation. Many within the Bank have argued that there are better barometers, which are not weighted so heavily to structural price disinflation. Among the disillusioned BoJ cadre, there appears to be universal preference for Nakaso. While he has given few hints he is prepared to depart from the current approach, anyone who buys into the idea that the inflation outcome is due to structural factors will be more hawkish in the event of cyclical price pressures. Even a more hawkish governor may find himself constrained from hasty policy adjustment. Abe’s fiscal plan has prioritised the debt-to-GDP ratio. This ratio has improved as interest rates have fallen even as nominal GDP growth has increased. This dynamic could quickly end if: 1) the BoJ was deemed willing to pull back from its YCC framework; and 2) it sought an early exit from unconventional policy.
Emerging Markets - An ode to Zhou
The impending retirement of China's longstanding central bank governor, Zhou Xiaochuan, was effectively confirmed last week when his name was left off the list of members of the Communist Party's Central Committee. Although timing is unclear, some reports suggest Zhou may step down around March next year. Zhou will be hard to replace. After nearly 15 years at the top of the People's Bank of China (PBOC), Zhou is the longest serving Chinese central bank head since the founding of the People's Republic of China and longest serving current head of any of the world's major central banks (see Chart 10). He has seen China through massive changes and steadfastly handled what is among the most difficult mandates of any central bank. Although there have been recent setbacks in his efforts to open the capital account and reform the exchange rate, Zhou will be most remembered as one of China's leading modern reformers. First as head of the securities regulator and then as central bank chief, he played an integral role in establishing China's capital markets, reforming monetary policy tools, ending a direct peg to the dollar, freeing domestic interests rates, and elevating the RMB to reserve-currency status. As the head of a politically constrained central bank, he has shown remarkable skill at persuading politicians to adopt reforms that were in the best long-term interest of China. He once said that for financial and economic reforms to succeed, two conditions need to be met: first, they need a sponsor, someone who will convince and cajole senior leaders; second, they need to be tied to other national objectives. The IMF's Special Drawing Right is a good example of such a strategy; Zhou adeptly used this as a tool for promoting currency and capital account reforms while convincing party leaders that it was all necessary for boosting China's global influence.
With China set to lose one of its most effective proponents for reform, how could Zhou's replacement affect the trajectory of policy? Regardless of who is chosen there are two risks that emerge from PBOC succession – the first is that the next governor does not take up the mantle of pushing reforms and the overall efforts behind financial liberalisation loses momentum. As Zhou himself stated, reforms need effective sponsors; if the next governor chooses not to push reform efforts it heightens the risk that systemic imbalances increase further (see Chart 11). Second, Zhou's reforms of the PBOC's tools have increased the effectiveness of monetary policy and added a modicum of independence to the PBOC. If the next governor is a political acolyte or lacks the same policy credibility as Zhou, the PBOC could struggle to effectively carry out its mandate. So far three names have been floated as potential successors: Guo Shuqing (current chairman of CBRC), Jiang Chaoliang (Hubei Party secretary), and Liu Shiyu (current chairman of CSRC) have been selected to be in the central committee suggesting they all may have a shot for the top position at the PBOC. The one clear trend that emerges from these three candidates is that efforts at containing financial sector risks and implementation of tighter financial regulation will likely continue to be a very high priority. Guo's experience includes cleaning up the banking sector as head of Shandong province, and since taking the role as top banking regulator has released some of the tightest regulations to date; Jiang played a role in liquidating a massive non-bank financial institution that went bankrupt in 1998; and Liu has advocated capital markets reform. All three could take up the mantle, time will tell.