Monday, June 8, 2015

Central Banks: Pixie Dust
The latest global economic indicators are pointing to more growth and less deflation. Below, I review the likely response of the major central bankers:

(1) BOJ. Peter Pan is running monetary policy in Japan. In his opening remarks at a conference in Tokyo on Thursday, BOJ Governor Haruhiko Kuroda said:
I trust that many of you are familiar with the story of Peter Pan, in which it says, "The moment you doubt whether you can fly, you cease forever to be able to do it."
The WSJ observed:
Japan’s central bank chief invoked the boy who can fly to emphasize the need for global central bankers to believe in their ability to solve a range of vexing issues, whether stubbornly sluggish growth or entrenched expectations of price declines. Kuroda added, "Yes, what we need is a positive attitude and conviction."
Japan’s monetary base continues to fly, rising 36% y/y and 118% since April 2013, when the BOJ started to increase it dramatically as one of the three “arrows” of Abenomics. All this liquidity succeeded in devaluing the yen, boosting profits and stock prices, and providing some lift to the economy by stimulating exports. However, the main goal was to stop deflation. Unfortunately, the headline CPI rose just 0.6% y/y during April, with the core rate (excluding food & energy) up just 0.4%.

(2) ECB. Bond yields jumped higher on June 2, when May’s flash CPI for the Eurozone showed a gain of 0.3% y/y, up from a recent low of -0.6% during January. In addition, the core rate rose from a series low of 0.6% during April to 0.9% during May. That doesn’t seem like much, but investors bailed out of bonds fast. Then, in his press conference on June 3, Mario Draghi, when asked about the backup in yields, responded:
But certainly one lesson is that we should get used to periods of higher volatility. At very low levels of interest rates, asset prices tend to show higher volatility, and in terms of the impact that this might have on our monetary policy stance, the Governing Council was unanimous in its assessment that we should look through these developments and maintain a steady monetary policy stance.
Instead of offering bond investors more pixie dust, Draghi was more like Captain Hook, listing five reasons why yields have risen recently: better growth, higher inflation expectations, more supply of short-term bonds, self-perpetuating volatility, and poor liquidity. He said that the current pace of dusting would be maintained.

(3) Fed. In many ways, Japan’s poor economic performance and chronic deflation, along with the BOJ’s attempts to cure these problems with ultra-easy monetary policies, have been pacesetters for other major economies. Fed officials hope that’s not the case for the US, and are signaling that they believe that the economy may be ready to fly on its own soon and won’t need as much pixie dust to do so.

On Friday, in a lunch speech following the release of May’s employment report, FRB-NY President Bill Dudley reiterated that the Fed is still on course to start lifting the federal funds rate later this year, confirming similar comments recently by Fed Chair Janet Yellen and Vice Chair Stanley Fischer. Dudley said:
I still think it is likely that conditions will be appropriate to begin monetary policy normalization later this year.
Like his two Fed colleagues, he indicated that he hopes that the markets won’t be too upset:
How will financial markets react to the onset of normalization? My own view is that there likely will be some turbulence. After all, lift-off will represent a regime change after more than six years at the zero lower bound.
According to Dudley, if markets react badly, the Fed will back off:
If a small rise in short-term rates were to lead to an abrupt increase in term premia and bond yields, resulting in a significant tightening in financial market conditions, then the Federal Reserve would likely move more slowly--all else equal.
Presumably, if the dollar soars and stock prices plunge, the Fed will wait awhile before even considering lifting rates again.

Our “one-and-done” scenario for this year is that the FOMC will vote to increase the federal funds rate by only 25bps at the September 16-17 meeting of the policy-setting committee. At least three other FOMC participants have recently implied no rush to raise rates: 1) FRB-Boston President Eric Rosengren (a non-voter this year) said in a speech last Monday that the US recovery is too weak; 2) In her maiden speech on monetary policy last Tuesday, FRB Governor Lael Brainard suggested she does not support a rate increase at the upcoming June policy meeting; 3) FRB-Chicago President Charles Evans (a voter) said in a speech last Wednesday said he does not expect rates to rise until next year.

Last year, on October 6, I first predicted that one-and-done was the most likely scenario for the FOMC in 2015 because the strength in the dollar could complicate the Fed’s plans to normalize monetary policy.
(Based on an excerpt from YRI Morning Briefing)