FLASH ECONOMICS. If central banks refrain from hiking interest rates because financial market volatility is high, then it will become even higher

Transcription

1 ECONOMICS ECONOMIC RESEARCH September 1 - No. 7 If central banks refrain from hiking interest rates because financial market volatility is high, then it will become even higher It would be very concerning if high volatility in financial markets is one of the reasons why central banks are refraining from exiting their highly expansionary monetary policies (in addition to the weakness of emerging economies and China). Indeed, this reason has been explicitly cited in the case of the Federal Reserve. Yet it is highly expansionary monetary policies that create high volatility in financial markets: zero interest rates are conducive to debt-leveraged purchases of financial assets and overabundant liquidity flows from one asset class to another. The result is a vicious circle: high financial market volatility keeps monetary policies ultraexpansionary, which generates even more volatility. Author: Patrick Artus

2 Interest rate volatility: One of the three reasons often cited to explain the Fed s status quo The Federal Reserve s decision to not raise its interest rates can be explained by three factors: 1- Some particular features of the US economic recovery, in particular the persistently low participation rate (Chart 1A), the creation of unsophisticated jobs in restaurants, retailing and transport (Chart 1B) and the lack of a clear upturn in wages (Chart 1C). That said, the US recovery is robust (Chart 1D) and, given actual growth, should bring about an increase in interest rates. Chart 1A United States: Unemployment and participation rate (as %) Chart 1B United States: Month-on-month change in employment by sector (in thousands of people) Participation rate (LH scale) Unemployment rate (RH scale) Restaurants, hotels and leisure Retailing + transport 7 Sources: Datastream, BLS, Natixis Sources: IHS Global Insight, BLS, Natixis Chart 1C United States: Wage (non-farm payrolls, Y/Y as %) Hourly earnings Weekly earnings Chart 1D United States: Real GDP growth, productive investment and household consumption (in volume terms, Y/Y as %) GDP Productive investment Household consumption Sources: Datastream, BLS, Natixis Sources: Datastream, BEA, Natixis Flash 1 7 -

3 - The economic problems of China (Charts A and B), emerging countries other than China (Chart C) and commodity-exporting countries (Chart D). But these problems bear no relationship with the Federal Reserve s policy: - The Chinese economy is suffering from its loss of competitiveness (Chart E); - Emerging countries other than China are beset by serious supply-side problems: insufficient skilled labour, electricity production (Chart F) and transport infrastructure; - Commodity-exporting countries are suffering from the weak demand in China and other emerging countries, which has led commodity prices to decline (Charts G and H). Chart A China: PMI index and manufacturing production Manufacturing PMI (Markit, LH scale) Manufacturing production (Y/Y as %, RH scale) Chart B China: Exports, imports and investment (Y/Y as %) Exports in volume terms Imports in volume terms Investment in machinery and equipment (in value terms) 1 Sources: Datastream, NBS, Markit, Natixis Chart C Emerging countries as a whole excl. China: GDP growth and manufacturing production (Y/Y as %) Chart D Commodity-exporting countries*: Real GDP growth (Y/Y as %) 1 Real GDP Manufacturing production 1 (*) OPEC + Russia + Africa + Canada + Australia Flash 1 7 -

4 1 1 Chart E China: Unit labour cost and real trade-weighted exchange rate Real trade-weighted exchange rate* (:1 =, LH scale) Unit labour cost (as % per year, RH scale) (*) (*) Rise = real appreciation of the currency Chart F Electricity production (KWh per inhabitant) United States Euro zone China Emerging countries as a whole excl. China Chart G Commodity prices 7 Sources: Datastream, World Bank, Natixis Chart H Price of non-precious metals (:1 = ) Oil prices (Brent, USD/bbl, LH scale) Coal prices (:1 =, RH scale) High financial market volatility (equities, Charts A and B, emerging currencies, Chart C), which the Federal Reserve fears would be exacerbated if it increased interest rates in the United States. Chart A Stock market indices (1:1 = ) Chart B Shanghai SE A stock market index (1:1 = ) 1 1 S&P Euro Stoxx /1 1/1 1/1 1/1 1/1 7 1/1 1/1 1/1 1/1 1/1 7 Flash 1 7 -

5 Chart C Exchange rate of emerging countries excl. China against the dollar (:1 = ) In this Flash we will focus on the absurd nature of this third argument. Expansionary monetary policies cause high volatility in markets One of the arguments used to explain the Federal Reserve s decision not to hike its interest rates on 17 September 1 was that it was difficult to raise interest rates given the high volatility in financial markets. This argument makes no sense: it is the highly expansionary monetary policy that has led to high volatility in financial asset prices. The very low interest rates enable investment funds to borrow to buy assets (Chart shows the very rapid increase in the size of these funds). This is even more concerning insofar as the assets bought are illiquid and so cannot be sold in the event of a liquidity crunch. Chart United States: Total assets in investment funds (all types, in USD bn) Sources: Datastream, FoF, Natixis Flash 1 7 -

6 The abundant liquidity flows from one asset class to another and increases the variability of the prices of these assets (Charts A and B). Chart A United States: -day moving average of [S&P as daily % in absolute terms] Chart B -day moving average of [exchange rate of emerging countries as a whole excl. China against the dollar in absolute terms],,,, 1, 1,,,,,,,,,,, 1, 1,,, 1,,, ,,,,, ,, Keeping interest rates close to zero in the United States and not reducing the monetary base (Chart ) will therefore further increase volatility in financial markets. Chart United States: Monetary base (in USD bn) 1 1 Sources: Datastream, Fed, Natixis Conclusion: An absurd argument The fact that monetary policies have been kept highly expansionary can be explained by concerns regarding emerging economies, particular features of the economic recovery in contemporary economies or by the oft-cited idea that monetary policies should not be made less expansionary as long as volatility in financial markets is high. This argument makes no sense, as it is ultra-expansionary monetary policies that cause the high volatility, due to the possibility of buying assets with debt leverage and the shifts in liquidity from one asset class to another. The more central banks wait to exit their highly expansionary monetary policies, the higher volatility in asset prices will be and the harder it will be for them to exit these highly expansionary monetary policies using the same argument. Flash 1 7 -

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