The euro zone financial sector has taken over from China’s FX policy and the decline in oil prices at the forefront of the renewed financial market turbulence.
The Bank of Japan is also in the crosshairs of the financial markets, struggling to convince them that they have the tools to arrest the yen’s recovery, strengthen growth and reach its 2.0 per cent inflation target.
More generally, the crisis which started the year focused on a few specific issues is morphing into generalised scepticism about whether policymakers are capable of generating confidence and overturning fears about a return to recession.
The scepticism is, in turn, driving widespread risk aversion which is potentially much more concerning. Although global economic data does not appear to be signalling a recession, the loss of confidence in markets might lead to one if banks weaken, credit growth slows and policymakers become frozen in the headlights of the markets’ volatility.
In the euro zone, some are talking about the return of the 2011-12 “doom-loop” in which euro zone banks and sovereign states were negatively entwined, with attempted solutions to the peripheral debt crisis then only making matters worse for the banks and ultimately for growth, with today’s crisis a partial consequence of this. Negative interest rates are now being exposed as also making matters worse, not better, as banks’ profit margins are being damaged hindering, not helping, credit extension. The ECB is thought likely to double up on rate cuts in coming months in a bid to alleviate matters, but this may only compound the problem, highlighting that the limits of central bank monetary policy effectiveness might have been reached.
The Bank of Japan’s resort to negative rates has already been shown to have had little positive impact on its markets, with the yen pushing relentlessly higher in spite of governor Haruhiko Kuroda’s threat to cut interest rates even further into negative territory. Into this confusion the Fed chairwoman Janet Yellen sought to clarify the Fed’s intention to gradually tighten monetary policy last week, but seemingly failed to convince anyone that is a realistic likelihood, even though US economic fundamentals remain broadly positive.
If central banks cannot convince markets that they mean business, then this clearly speaks of a credibility issue on top of any fundamental disagreements that might also exist between them and the markets. This may in itself be an argument to actually go ahead and raise interest rates to reassert the Fed’s authority.
In reality the credibility problem goes way beyond the central banks, with disaffection with elected political leaders also a widespread phenomenon right now. This is manifest in the US election process, but it also has resonance across large parts of the developed world, especially in the euro zone and UK. Confidence in the ability of politicians to get ahead of the game when dealing with underlying problems has been low for some time, especially since the 2008-09 financial crisis, and recent experience shows that it is not improving.
With conventional and unconventional monetary policy measures appearing to be losing their impact, there are two other options that investors have begun to speculate about. One is the upcoming G20 meeting in Shanghai on February 26 through 27, which according to the European Central Bank executive board member Benoit Coeure will discuss ways to coordinate exchange rate policies. This has echoes of the Plaza Agreement and Louvre Accord of almost 30 years ago, but the reality is likely to be much less ambitious, reflecting a completely different set of circumstances. While engineering a softer US dollar might assist some of the emerging market economies that are laden with US dollar debt, it is doubtful if any such deal would go much beyond a very informal understanding that the US might hold back from tightening for a bit longer.
Another approach might be to use fiscal policy as an alternative means to spur growth. However, the fiscal room for manoeuvre appears limited in the parts of the world that really need it, or at least fraught with complications. In Europe and Japan debt levels are already high, and in the euro zone’s case government spending would probably come up against obstacles from fiscal policy hawks.
The US, on the other hand, does have some fiscal space, having cut its deficit from 10 per cent in 2009 to 2.5 per cent in 2015. Barack Obama has recently published his final budget, which envisages the deficit rising to 3.3 per cent this year, but politics will most likely prevent it from being passed; which of course reinforces the markets’ perception about a lack of leadership.
Tim Fox is chief economist and head of research at Emirates NBD.
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