Central bankers’ diverging paths could create damaging disharmony

November 28, 2013 12:01 pm

Central bankers’ diverging paths could create damaging disharmony

By Claire Jones and Ralph Atkins

For the past six years, the world’s main central banks have sung largely from the same hymn sheet – shoring up financial systems and printing money to support economies. Now, they are doing their own thing. Weak eurozone inflation data on Friday could fuel expectations of further stimulus measures from the European Central Bank. The Bank of Japan, meanwhile,has dropped heavy hints that if its aggressive asset purchase, or “quantitative easing” programmes do not drag the country out of deflation, it will step up action.But with the US economy returning to more normal health, the US Federal Reserve is looking to scale back, or “taper” its QE. At the Bank of England, the talk is about an interest-rate increase, maybe by the end of next year.

The divergence runs the risk of creating damaging disharmony – especially in currency markets – and with interest rates at rock bottom levels it will test further central bankers’ skills communicating their intentions to investors globally. With no historical precedent for actions central banks have taken, the risk is of a bumpy ride.

“The divergence . . . compounds the uncertainty that inevitably surrounds the aggressive use of unprecedented policies. There are likely to be false starts – as we have seen already in the US,” says Mark Cliffe, chief economist at ING bank, referring to the unexpected Fed decision in September against starting to taper its stimulus. “There is no consensus on how, or even if, these policies work. In a real sense, they are making it up as they go along,” he said.

Julian Callow, international economist at Barclays, added: “There is way more uncertainty attached to the economic impact, and hence calibration, of these non-conventional measures than central banks are generally willing to let on,” he said.

And in growing signs of concerns over the potential cross-border impact policy change can have on other major developed markets, the ECB warned this week that Fed tapering talk posed risks to eurozone financial stability.

The is way more uncertainty attached to the economic impact, and hence calibration, of these non-conventional measures than central banks are generally willing to let on

– Julian Callow, international economist at Barclays

Some central banks in smaller advanced economies could start raising interest rates early next year – New Zealand is tipped to be the vanguard. “When that news really starts to hit us, it is going to be very significant for forex,” says Jane Foley, foreign exchange strategist at Rabobank.

Highlighting how central banks have acted in tandem, their balance sheets have all expanded massively since the collapse of Lehman Brothers investment bank late 2008. While the Fed has grabbed the headlines and created market volatility merely by mentioning the possible tapering of its $85bn-worth of monthly bond buying, its balance sheet has expanded by almost $1tn to $3.86tn since the start of the year.

Lately the ECB’s balance sheet has shrunk by more than a fifth to €2.94tn as banks have repaid funds borrowed through its three-year longer-term refinancing operations. Central banking is not just about printing cash, however. It is also about setting the tone and conditioning expectations. Both the ECB and BoJ are maintaining, in central bank speak, a firm “downward bias”.

ECB policy makers have been forced to react to clear divergences in economic performance. Weak eurozone economic growth has been accompanied by high unemployment which, unlike in the US, shows scant sign of falling and inflation far below the ECB’s target of an annual rate “below but close” to 2 per cent.

Central banks’ record this year in effecting shifts in policy smoothly is not great. Initial hints about “tapering” by Ben Bernanke, US Federal Reserve chairman, in May pushed US market interest rates sharply higher and created levels of volatility not seen for two years.

“Increased volatility will be a feature of the post-Fed QE world,” says Ken Wattret, European economist at BNP Paribas. “But the problem of exiting from exceptional policy measures is probably a bigger concern than the complications associated with central banks heading in opposite directions when it comes to asset purchases.”

Despite the US tapering talk, eurozone market interest rates have remained relatively stable. Yields on German Bunds, which historically have been closely correlated with US Treasury yields, have decoupled. Even when the Fed does start tapering, policies will remain ultra-accommodative across advanced economies, adds Peter Oppenheimer, chief global equity strategist at Goldman Sachs. “The broader message is that policy is going to remain very accommodative.”

The ECB will be anxious, however, to ensure US Fed action does not prematurely tighten monetary policy conditions in the eurozone by pushing up borrowing costs in the region’s weakest economies.

Divergence in central bank policies, “is a good sign to the extent that it tells you that the US economy is getting back to something like normal,” argues Stephene Deo, head of global asset allocation at UBS. “You always have this phase where the US starts to pick-up and the Europeans are still easing. But there will be a pick-up in instability during the transition.”