The Monetary Engine Ticks Along

Markets rallied strongly in response to the Fed’s dovish-sounding March statement—only for a number of Federal Open Market Committee (FOMC) members to immediately insist that the statement had been misinterpreted and that, in fact, the FOMC’s position was really not all that dovish. Chair Janet Yellen put the discussion to bed in her speech at the Economic Club of New York, where she said that, although the economy is doing “fine,” interest rates will only be increased at a gradual pace, probably with just two hikes in 2016. In response to the relentless rally in financial markets, the FOMC decided in its April meeting to issue a marginally more upbeat message—that downside risk from the tightening of financial conditions has abated. In doing so, it opened the door for the first of the 2016 interest rate increases to occur in June.

The European Central Bank’s (ECB) increased its support for the markets at its April policy meeting, where it also revealed a widening of the range of issuers that qualify for its new corporate bond purchase program. Credit markets obviously liked the message: Investment-grade credit spreads tightened by almost 5bps in the days following the announcement.

Is this all about propping asset markets at unsustainable levels? The transmission mechanism from monetary policy to the real economy is multifaceted and works both through the asset and the liability side of real economy balance sheets. A widening of credit spreads frustrates access to, and increases the cost of, finance for companies. In turn, this depresses investments and hiring. Simultaneously, wider credit spreads lead to losses for households that hold corporate bonds either directly or through their pension savings. A reduction in net worth from a financial loss depresses consumption.

Despite the benefits of looser credit conditions over the past six to eight weeks, the data on global growth and the real economy sentiment indicators remain soggy. What would the data have looked like had the Fed and the ECB not stepped in? I believe that the risk of a global recession was increasing rapidly and that the forcefulness of the Fed and the ECB’s responses was, therefore, justified.

The April policy meeting at the Bank of Japan (BoJ) was another disappointment. The combination of low and falling inflation, weak and weakening growth, falling equity markets, and a rapidly appreciating yen prompted widespread speculation that the BoJ would increase its ETF purchase program and potentially push interest rates further into negative territory. Once again, however, the BoJ delivered nothing.

Why would the BoJ not respond to conditions that look so ripe for additional stimulus? There are two main reasons, in my view. First, its venture into negative interest rate territory has been anything but popular with the general population and Japan, Inc. (negative interest rates were never going to be an enticing prospect for a nation of savers). Second, Governor Haruhiko Kuroda’s modus operandi suggests that he believes that monetary policy is most potent when it is delivered as a surprise. Given the unpopularity of negative interest rates, maybe Kuroda could not garner the political support he needed to deliver a "shock and awe" loosening of monetary conditions and opted instead to surprise everybody by doing nothing. The BoJ is now in a holding pattern, waiting for popular and political support to build as the appreciation of the yen puts additional pressure on the domestic economy.

2016-GL-3931

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