The Global Economy No. 6 - September 11, 2012: Awaiting the central banks

1. The Global Economy
Monthly letter from Swedbank’s Economic Research Department
by Cecilia Hermansson No. 6 • September 11, 2012
Awaiting the central banks
 The European Central Bank (ECB) has delivered and had a positive effect on
interest rates in the short term at least. Now responsibility falls on the crisis
countries to ask for support and implement reforms. The terms that the ECB has
now set for bond purchases appeal to Germany (though not yet the Bundesbank),
but make it harder for the central banks to conduct monetary policy and at the
same time maintain their political independence. On the other hand, central banks’
independence has already been limited, especially in the euro zone, where by far
the biggest hope of a savior of the currency union rests with the ECB.
 In contrast with the ECB, the Federal Reserve (Fed) is likely to launch a new
program of quantitative easing – this time with a greater variety of asset
purchases. The commodity and financial markets are pleased by this
“unconventional monetary policy,” which would add liquidity, but the impact on
unemployment will be small.
 While many people expect the central banks to mitigate the crisis – and they
certainly should try to – the effect on the real economy, including growth and the
labor market, will be small, since monetary policy isn’t as effective when balance
sheets are being repaired and interest rates are already low. Instead more should
be done to develop “unconventional fiscal policy,” e.g., prioritize structural policy,
broaden the tax base, introduce some form of tax on high income earners and cut
spending that isn’t motivated by growth and employment targets.
Hope rests on looser monetary policy Fourthly, there is a monumental institutional crisis
under way in the currency union, which will take
There are several reasons why the focus has
time to resolve and will require all the support that
shifted as much as it has to central banks right now.
can be mustered in a situation where the crisis is
The most obvious reason is the lower demand that also linked to the banks’ financing in recent years of
is spreading from the crisis countries in southern escalating government debt. For the euro, the hope
Europe to northern Europe and then to emerging is that the European Central Bank (ECB) will
markets, Japan and the US. Looser monetary policy unravel the knots that politicians cannot seem to (at
should in theory ease the slowdown. least not quickly enough).
Secondly, debt restructuring in the public sector The economic malaise is obvious, especially since
means tighter fiscal policy, which can be offset at the slowdown in China and India has been worse
least in part by slightly looser monetary policy. than expected and in turn has spread to Japan,
Germany and other export-oriented economies.
The third is debt restructuring in the private sector – Manufacturing industry has announced cutbacks,
not least the banking sector – which creates the and while the service sector is holding up better, it
need for support from lower interest rates and more won’t be able to avoid a downturn either.
liquidity in order to avoid even greater credit
austerity. At the same time it should be noted that US equities
and oil prices have not yet adjusted to the slower
Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46-8-5859 7740
E-mail: ek.sekr@swedbank.se Internet: www.swedbank.com Responsible publisher: Cecilia Hermansson, +46-8-
5859 7720, Magnus Alvesson, +46-8-5859 3341, Jörgen Kennemar, +46-8-5859 7730, ISSN 1103-4897

2. The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 6 • September 11, 2012
economy, though this is likely to happen in the near depression and deflation is greater than that of
future. Commodity prices will decline if demand inflation. At the same time interest rates are already
slows, but could hold up if supply disruptions low and the marginal benefit of another quantitative
continue. easing has decreased. We also know that after a
financial crisis, when balance sheets are in need of
Global purchasing managers index, S&P index and oil prices repair, it is more difficult to find effective monetary
80 140 policy. In reality, fiscal policy should be more
75 S & P 500 130 effective, but it cannot be tapped when government
70 120 debts have already risen to such high levels.
65 P M I output 110
Consequently, politicians should implement more
extensive fiscal reforms and cut any spending that
Index (diffusion)
global
60 100
doesn't benefit growth and employment, while
55 90 broadening the tax base, eliminating exemptions
50 80 and temporarily introducing a tax on high-income
45 O il price 70 earners (but not to the same extent as in France).
40
brent in 60
That would leave enough room to finance
USD educational investment and labor market measures,
35 50
especially for the young, after which greater focus
30
07 08 09 10 11 12
40 can also be placed on structural policy.
So urce: R euters EcoW in
In emerging markets such as India and Brazil,
One way to boost confidence in the commodity and expectations of significantly lower interest rates
financial markets is if the central banks decide on could come to naught, since inflation has already
another quantitative easing or additional rate cuts. risen and central banks have to be cautious to
New liquidity in Japan, the US and UK would avoid another period of overheating. Even China
improve the mood of global stock markets at the cannot reduce its reserve requirements and interest
same time that the ECB’s bond purchases (which rates as much as many people expect, since
are sterilized and cannot be counted as quantitative officials will show more restraint this time to avoid
easing) would at least temporarily increase another real estate bubble.
confidence in the euro’s survival. Government bond
yields have declined since the ECB announced it ECB is developing new form of support
was willing en masse to buy the bonds of the crisis The ECB decided not to cut its benchmark rate on
countries, provided that they implement reforms September 6, so it remains at 0.75%. Instead, the
which are supervised by the EU and the IMF. focus was on its new bond buying program, at the
same time that inflation is still relatively high and the
Two-year bond yields for Spain, Italy, Germany and the UK ECB may want to have ammunition left this fall.
8 What’s more, the importance of a rate cut is
Italy
7
questionable under the circumstances, although it
would probably be smart to cut rates slightly or in a
6
couple of stages if the recession worsens.
5
Spain Reducing financial fragmentation in the euro zone,
4 which means that the interbank markets have
Percent
3 become more national and that interest rate
differentials between countries are high, is instead a
2
goal for monetary policy. The ECB has therefore
1 launched a new bond buying program it calls
0
Germany
UK
Outright Monetary Transactions (OMTs).
-1 This is how OMTs work. The ECB has promised to
07 08 09 10 11 12
buy bonds with up to a three-year maturity from
Source: Reuters EcoWin
crisis countries that have incurred rising and
It seems only reasonable that the central banks unsustainably high financing costs for their debt.
maintain an accommodative monetary policy given There is no quantitative limit on how much the ECB
the arguments mentioned above. In developed can buy, and it will buy the bonds in the secondary
countries, primarily in Europe, the threat of market. In return the crisis country must apply for
2 (4)

3. The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 6 • September 11, 2012
support from the rescue funds and implement same way that they have been critical of its
reforms overseen by the EU and the IMF. There are predecessor, the Securities Market Program (SMP),
no longer seniority levels affecting bond purchases which did not explicitly require reforms? Weidmann
by other creditors, meaning that if a country defaults feels that the ECB is resorting to monetary
on its payments the ECB would lose its money financing, which is prohibited by the EU Treaty. The
along with other creditors. The ECB will not allow risk is that taxpayers will ultimately end up footing
itself to be affected by credit downgrades by ratings the bill if the crisis countries fail to lift themselves
agencies, which previously forced borrowers to find out of the crisis, creating a so-called death spiral
new collateral. To mitigate the risk of future with lower demand, austerity, etc. Then it would left
inflation, the purchases will be sterilized, which mainly to German and French taxpayers to clean up
means that the banks will deposit with the ECB an the ECB’s balance sheet.
amount equivalent to the bonds they sell, which the
ECB will pay interest on, or that the ECB will issue It is worth noting that Germany’s weight was 27%,
treasury bills in exchange for the banks’ liquidity. In but as Ireland, Greece and Portugal no longer have
this way the OMTs cannot be characterized as a weight Germany’s has risen to 29%. If Spain and
quantitative easing, since no additional liquidity has Italy were to seek support, they too would no longer
been added to the monetary system. be guarantors and their weights of 13% and 19%,
respectively, would disappear, which would raise
The financial markets have already responded Germany’s weight much more than to date.
positively to the program, since interest rates have
fallen not only for short-term but also longer Euro zone GDP growth and growth in money supply (M1)
maturities. The stock market has reacted positively 5,0
<---- GDP Growth
as well. The question, however, is whether the 4,0 13,0
effects will be longer lasting this time. What are the 3,0
problems and uncertainties associated with OMTs? 2,0
10,0
Is this just another proverbial can that will be kicked 1,0
7,0
down the road by politicians to buy themselves
Percent
Percent
0,0
time, but where the measures are soon revealed as -1,0 4,0
being insufficient?
-2,0
1,0
Against its will, the ECB has now taken another -3,0
Growth in real M1 --->
step further from conventional monetary policy, -4,0
-2,0
since the bond purchases will be conditional on -5,0
political reforms. This is risky. What does -6,0 -5,0
conditionality mean in terms of the ECB’s 96 98 00 02 04 06 08 10 12
independence? Will it stop buying bonds if a Source: Reuters EcoW in
country’s loan costs are in line with fundamentals? We are also waiting for Germany’s Constitutional
How easy will it be to stop buying bonds from a Court to approve the ESM, the more robust of the
country that doesn't institute the intended reforms,
two rescue funds, which can provide support
and will the ECB be able to sell off these bonds without appealing to national parliaments, thereby
even though it could cause a panic and crisis reducing the sovereignty of Germany and other
countries may have to exit the currency union? Is
countries. The most likely outcome is that the court
the program expected to reduce interest rates in the will approve the ESM, but add conditions. The focus
crisis countries even if they don't seek support is also on the parliamentary election in the
simply because expectations of support have now
Netherlands, which could mean reduced support for
been created? If that's not enough, Spain and “rescuing” the euro, as well as statements by the
perhaps even Italy may have to ask for help from troika on the Greek reform program, which is the
the program, which could take time.
basis for new support payments.
It has been announced that the IMF will play a part The ECB is probably moving in the right direction,
in supervising the program in the future, but it is since there really isn't another short-term solution to
unlikely that the IMF will contribute any money,
the euro zone’s fragmentation problem. At the same
which will reduce its influence. time the conditionality that has been added to the
What does it mean in practice that the German bond purchases make it more complicated for the
central bank, the Bundesbank, and its president, central banks to act and endanger their political
Jens Weidmann, have opposed the OMT, in the independence. The question is whether there would
3 (4)

4. The Global Economy
Monthly newsletter from Swedbank’s Economic Research Department, continued
No. 6 • September 11, 2012
have been any difference if the ECB had instead The US labor market has performed weakly to date,
continued the SMP, but Germany wouldn't have and the addition of 96 000 new jobs was nothing to
accepted that, since the volumes are now expected get excited about, since no fewer than 368 000
to be much larger. Furthermore, the central banks people dropped out of the labor force. As a result,
have already lost some of their independence. unemployment fell to 8.1% despite that the increase
in employment wasn't even enough to keep pace
The future of the currency union in reality rests with with the normal expansion of the labor force. Now
reforms by the crisis countries, decisions by euro expectations of QE3 are increasing and it is likely
politicians to expand their cooperation to include that a decision will be made as early as this week.
fiscal policy and bank supervision, economic policy
measures and better decision-making process. The US employment (change in millions)
focus is now shifting to Spain and Italy and whether 0,75
they decide to seek help from the reform and
rescue programs. If they wait to do so, there is a 0,50
risk that the OMT’s impact on interest rates will be
0,25
as short-lived as the SMP’s was.
Persons (millions) 0,00
The Fed eases off the gas
-0,25
At the much-publicized annual central bank
conference in Jackson Hole, Fed Chairman Ben -0,50
Bernanke discussed options for easing monetary
policy with interest rates already low. One -0,75
possibility is to announce that benchmark rates will
remain around zero even beyond 2014. It could -1,00
88 90 92 94 96 98 00 02 04 06 08 10 12
also stop paying banks to deposit money with the
Source: Reuters EcoWin
Fed, which could potentially lead to increased
lending. The most likely outcome is that the Fed will The question is how effective QE3 will be when
decide to launch a new round of quantitative easing there are structural problems in the US labor market
(QE3). To date this has not created the anticipated which have to be met with more targeted
level of growth and employment gains. Is there educational investment – a job for fiscal policy.
anything to suggest that this time will be any There is still cyclical unemployment, however,
different? One idea often heard is that the Fed (or which could be reduced if demand grows slightly
the Bank of England for that matter) could buy faster. As long as there is a lack of political will to
assets other than government bonds. This has compromise on the national debt and budget deficit,
been the model used for some time by Bank of small and medium-sized companies will remain
Japan, which even buys equities. Where do you uncertain, which will affect their willingness to invest
draw the line and how effective would it be to try to and hire. Once again, it’s fiscal policy that has to be
reduce mortgage rates by buying mortgage bonds called upon. Fiscal creativity or unconventional
instead? They would probably decline slightly more, methods are needed here as well.
and there are already signs of slight growth in
demand for housing and mortgage financing, but The commodity and financial markets will be happy
from very low levels. At the same time there is a with more liquidity, but it is doubtful whether the real
risk in placing every possible asset on the Fed’s economy, including growth and the labor market,
balance sheet. will react as hoped.
Cecilia Hermansson
Swedbank Swedbank’s monthly The Global Economy newsletter is published as a service to our
Economic Research Department customers. We believe that we have used reliable sources and methods in the preparation
SE-105 34 Stockholm, Sweden of the analyses reported in this publication. However, we cannot guarantee the accuracy or
Phone +46-8-5859 7740 completeness of the report and cannot be held responsible for any error or omission in the
ek.sekr@swedbank.se underlying material or its use. Readers are encouraged to base any (investment) decisions
www.swedbank.se on other material as well. Neither Swedbank nor its employees may be held responsible for
losses or damages, direct or indirect, owing to any errors or omissions in Swedbank’s
Legally responsible publisher
monthly The Global Economy newsletter.
Cecilia Hermansson, +46-88-5859 7720.
Magnus Alvesson, +46-8-5859 3341
Jörgen Kennemar, +46-8-5859 7730
4 (4)