Last week in global monetary policy Israel and Albania cut their rates as Israel became the first advanced economy to ease in 2014, illustrating the sluggish state of the global economy despite its gradual healing from the global financial crises.
With weak global demand keeping worldwide inflation at bay, currency depreciation is boosting import prices and thus inflation in pockets around the world, including in Brazil and Zambia, with both banks raising rates last week as they continue their tightening cycles started in early 2013.
Eight rate increases through the first 9 weeks of this year compared with 11 rate cuts by the 90 central banks followed by Central Bank News shows that the trend in global monetary policy is shifting toward tightening though rates are likely to remain very low for years to come.
Viewed in percentage terms, rates have already been raised 10 percent of this year’s 79 monetary policy decisions compared with only 5.3 percent through the 52 weeks of 2013.
Central banks in advanced economies cut rates 9 times in 2013 as the Bank of Israel cut three times, the European Central Bank and the Reserve Bank of Australia cut twice and Sweden cut once. Denmark managed to both raise and cut its rate last year. But Denmark’s central bank is an anomaly among advanced economies as its monetary policy is purely aimed at defending the krone’s exchange rate to the euro so in most cases it shadows the ECB.
The global shift toward higher rates is being driven by the U.S. Federal Reserve’s gradual wind-down of quantitative easing, underpinned by an improving U.S. economy.
Apart from the distortion that ultra-low rates are having on financial assets and investors’ behavior, low rates also means that major central banks have little ammunition with which they can respond to an economic shock, an unsettling prospect that has been raised by Russia’s aggressive behavior in the Crimean peninsula.
While much of the current debate around monetary policy in the U.S. and the UK is focused on the timing of rate rises, the issue of the future level of rates is increasingly being discussed.
Mark Carney, governor of the Bank of England (BOE), has on several occasions, including his Feb. 12 presentation of the Bank’s new forward guidance, said that rates in the medium term will be “materially lower than before the crises” due to the headwinds of public and private deleveraging, strains in the financial system, weak global demand and a high sterling exchange rate.
Last week Dennis Lockhart, president of the Atlanta Federal Reserve, echoed this sentiment, saying he expects the U.S. to be “in this low interest rate environment for quite a while.”
David Miles, an external member of the Bank of England’s Monetary Policy Committee, added fresh perspective to this debate in a speech last week on “The transition to a new normal in monetary policy.”
While Miles acknowledged the above-mentioned headwinds to demand, he believes that the financial crises has also led to a much more fundamental and longer-lasting change in investors’ risk perception.
“I suspect the memory of the crises and the effect it has had on the risk perceptions will last longer than the impact on spending and taxes of the need to rebuild balance sheets,” Miles said on Thursday in London.
To help examine investors’ perception of risk, Miles looked to economic models developed by the American economist Robert Barro, senior fellow at Stanford University’s Hoover Institution and well-known critic of government stimulus programs.
The events surrounding the global financial crises were largely considered inconceivable by most economists and investors during the so-called Great Moderation from the mid-1980s to 2007.
But now, investors are considering such crises as rare, but not inconceivable. The implication is that assets that are low in risk, such as indexed bonds issued by governments with a small risk a default, are viewed as much more attractive with a corresponding decline in their yields.
This new post-crises perception risk will tend to increase the difference between the returns on safe assets, which are closely linked with rates set by central banks, with the returns on riskier assets that are more closely linked to an economy’s performance, such as corporate debt.
“A rise in that spread between safe rates and rates on riskier assets is likely to mean that the rate set by a central bank should be lower,” said Miles, professor at London’s Imperial College.
Interestingly, Miles finds that BOE’s Bank Rate historically has been around 5.0 percent. Not only was this the average rate from 1997, when the BOE was granted independence, to the end of 2007, but also the average rate in the 320-year-history of the Bank of England, from its creation in 1694 to 2014.
Underlying this 5.0 percent Bank Rate was an average inflation rate of 2.0 percent so historically, the risk-free real UK interest rate has been around 3 percent, Miles said.
“Indeed there are reasons to think that for some time to come the level of Bank Rate that will keep demand and supply consistently in balance and keep inflation at the target rate is likely to be below (maybe well below) the 5% figure,” he said.
Spreads between lending rates and Bank Rate may come down in coming years once banks have built up their capital to more adequate levels and if competition in the banking sector picks up. But spreads on risky lending, whether by banks or by capital markets, are unlikely to fall to where they were before the crisis, partly because those pre-crises spreads unsustainable.
Miles shows how the spread of corporate bond rates over 5-year government bond rates fell to an average of 0.9 percent in the period from 1997-2007 from 1.6 percent during 1938-1996. The spreads then jumped to 3.5 percent from 2008-2013 and has now narrowed to 2.0 percent in January 2014.
A parallel example is how mortgage rates fell to unprecedented lows in the decade before the crises. The spread of mortgage rates over the BOE’s Bank Rate averaged 1.2 percent from 1938 through 1996 but then narrowed to only 0.5 percent from 1997 through 2007. From 2008 through 2013 it then widened to 2.7 percent as banks’ perception of risks changed dramatically. Since then it has narrowed to 1.9 percent in January.
Financial liberalisation may be one factor behind lower spreads during 1997-07 compared to 1938-96. But another likely reason for Miles is that in the years before the crisis, lenders and borrowers underestimated the risk that debt would not be repaid. Those risks are now perceived to be significantly higher and are likely to stay higher for many years.
Another perspective on the future evolution of monetary policy came from bitcoin when Tokyo-based Mt. Gox, one of bitcoin’s biggest exchanges, went dark under mysterious circumstances, casting doubts on the future viability of the virtual currency.
The collapse of Mt. Gox, including a reported 744,000 missing bitcoins – worth over $400 million – has showcased the complete lack of regulation and legal status of the bitcoin system.
Nevertheless, Federal Reserve Chair Janet Yellen, in her Thursday testimony to a Senate committee, said Congress should consider ways to regulate virtual currencies as the Fed currently has no jurisdiction.
On the same day, Japanese Vice Finance Minster Jiro Aichi said that legally bitcoin was not a currency as it was not issued by the Bank of Japan. However, Aichi also said that any regulation of bitcoin should involve international cooperation to avoid loopholes.
These two comments show that central bankers and policy makers believe digital currencies are likely to play a growing role and they are now starting to consider how to regulate them in the future.
LIST OF LAST WEEK’S CENTRAL BANK DECISIONS:
- Albania cuts rate by a further 25 bps to 2.75%
- Brazil raises rate by 25 bps, 8th increase since April 2013
- Moldova holds rate steady at 3.5% as inflation eases
- Fiji maintains rate with inflation and FX reserves stable
- Egypt maintains rates, sees limited inflation risks
- Angola holds BNA rate, raises liquidity absorption rate
- Zambia raises rate 50 bps on upside risks to inflation
- Colombia holds rate, inflation seen moving toward target
TABLE WITH LAST WEEK’S MONETARY POLICY DECISIONS:
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This week (Week 10) eight central banks will be deciding on monetary policy, including Australia, Uganda, Canada, Poland, Malaysia, the European Central Bank, the United Kingdom and Serbia.
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