Last week three central banks (Thailand, Namibia and Iceland) held their rates steady while Turkey again raised its short-term lending rate to ease the pressure on its currency as investors have become increasingly jittery over next month's possible reduction in asset purchases by the U.S. Federal Reserve.
Emerging markets - especially Turkey, India and Brazil - continue to respond to an outflow of capital and currency depreciation through a combination of foreign exchange market intervention, regulatory or macro prudential measures and interest rate hikes.
An explanation of why investors have reacted with such force and determination to the Fed’s plan to slowly wind down quantitative easing (QE) came from papers delivered this week to the Jackson Hole Economic Symposium.
The papers didn't just dissect the recent and past volatility in global markets, they also made specific proposals on how the Fed should unwind its large-scale asset purchases (LSAPs), why central banks should strengthen their cooperation on exiting QE and how nations can limit some of the negative consequences of the global financial cycle.
Due to uncertainty of how large-scale asset purchases precisely affect economic activity, the Fed has been deliberately vague in spelling out the conditions for increasing or decreasing asset purchases. This contrasts with the specific thresholds it has set for changing the fed funds rate.
One of the distinguishing features of the Fed’s large-scale asset purchases (LSAPs) is that they focus on longer maturity assets in an attempt to keep those yields low. But yields on longer assets are much more sensitive to expectations than shorter assets, putting the onus on the Fed to control those expectations.
The consequence of this deliberately vague and flexible stance is that investors have linked a gradual and measured tapering of these purchases – in itself a monetary stance that is looser than ever before - to the much more drastic step of raising the fed funds rate.
“By being imprecise in the state-dependence of LSAP policy, the Fed has left it to investors to form expectations over the future of LSAPs,” according to a paper presented by Arvind Krishnamurthy and Annette Vissing-Jorgensen.
“Investors only understand that LSAPs are a tool to be used when the zero-lower-bound is binding. Thus when the Fed communicates that it plans on not using LSAPs, investors assume that the zero-lower-bound will not be binding and that rate hikes will follow,” they wrote.
Krishnamurhy and Vissing-Jorgensen also proposed a specific plan for how the Fed should exit QE.
First, it should stop buying Treasury bonds and then sell its portfolio as this would have the least negative impact on economic activity. Secondly, the Fed should sell its higher-coupon, older mortgage backed securities and the final step is halting the purchases of current-coupon housing debt, the area where its asset purchases have had the largest economic impact.
In his paper, Robert E. Hall was relatively optimistic about the prospects for economic recovery given that most of the factors that led the U.S. into the 2007-2009 crises were self-correcting and were finally improving. However, he also cautioned the Fed against contracting its policy too early and raising the rate its pays on its reserves.
Another important point to emerge from Jackson Hole was the Fed’s influence on the movement of global financial assets.
In her paper, Helene Rey showed how global capital flows, asset prices, credit growth and financial leverage tend to move in sync with the VIX, a proxy for risk aversion in financial markets.
Rey then looks at the factors that drive the VIX and the global financial cycle and finds that it’s mainly the Fed’s policy stance.
In his paper, Jean-Pierre Landau touches on the same theme as Rey and finds that the flow of capital from investors’ portfolios has become much more volatile in recent years in comparison with banking flows and is now part of global liquidity.
Portfolio flows are thus also driven by risk appetite - reflected in the VIX - rather than interest rate differentials. Another recent feature is the growth in funds that focus on emerging markets. This allows investors to easily arbitrage between advanced and emerging economies.
The ultra-easy monetary policy in advanced economies in recent years means that risk appetite has become much more important in influencing the direction of global liquidity, amplifying the spillover of monetary policy from advanced to emerging markets.
Landau acknowledges that portfolio flows may be much smaller than direct investment or banking flows, but importantly they represent the “marginal investor, the one that instantly determines the market equilibrium and its price, with huge impact in times of stress when market liquidity dries up.”
The combination of daily fluctuations in the value of dedicated funds and their limited volume sets up the perfect conditions for runs by investors when risk perceptions shift, much as investors right now are repricing the risk of investing in emerging markets by demanding higher yields to compensate for likely currency losses in those countries faced with high current account deficits.
Once again, the papers presented at the Jackson Hole symposium were highly relevant to current economic challenges, just like Michael Woodford’s paper last year heralded the popularity of forward guidance.
If last year is any guide, there are three likely outcomes from this year’s symposium.
First, the Fed is likely to become much more specific in its guidance around the tapering of asset purchases.
Second, attempts to manage and control the free flow of capital across borders is likely to rise. Rey showed how the Fed’s policy is transmitted worldwide and she raises serious questions about the benefits countries have derived from the massive rise in cross-border investments.
Third, central banks worldwide are likely to strengthen their cross-border cooperation in coming years to better internalize the global spillover of domestic monetary policy, especially from advanced economies.
LAST WEEK’S (WEEK 34) MONETARY POLICY DECISIONS:
|COUNTRY||MSCI||NEW RATE||OLD RATE||1 YEAR AGO|
This week (week 35) seven central banks are scheduled to hold policy meetings, including Israel, Hungary, Pakistan, Brazil, Moldova, Fiji and Angola.
|COUNTRY||MSCI||DATE||RATE||1 YEAR AGO|