The limits of easy monetary policy

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1 The limits of easy monetary policy Investment Forum Ultra-easy monetary policy may in itself also feed new excessive credit booms. Globally, central bank rates remain close to all-time lows. But there are reasons to believe that monetary policy by central banks may have become too loose in the developed world. Financial instability risks are on the horizons. We therefore should take any further potential stimulus measures by the Central Banks with a pinch of salt. For asset prices to rise, it takes more than just a monetary stimulus. Stefan Hofrichter Global Head of Economics & Strategy Allianz GI Globally, central bank rates remain close to all-time lows at an average 0.5 % in advanced economies and 2.2 % when including emerging markets. While the US Federal Reserve (Fed) hiked interest rates in December of 2015 for the first time since bringing rates to basically 0 % in 2008, other major central banks, notably the European Central Bank (ECB), the Bank of Japan (BoJ) and the Swedish Riksbank, have lowered rates further, with the BoJ joining the ECB, the Swedish Riksbank, the Danish National Bank and the Swiss National Bank testing the waters of negative central bank rates. Rates have also been cut in 2016 in several emerging market economies, e.g. in India, Indonesia, Poland and Hungary. The ECB, the BoJ and the Riksbank have additionally decided to up their liquidity injections to the markets by increasing the size of their respective quant easing policy measures. While the Fed is still communicating (e. g. via the quarterly update of its famous dot charts ) that more rate hikes are likely this year, the market only assigns a probability higher than 50 % that there will be one more rate hike this year. Likewise, expectations for the first Bank of England (BoE) rate hike have been pushed back further into the future. Even a rate cut as the next likely step by the Old Lady on Threadneedle Street is no longer totally ruled out by market participants. In sum, nine years since the Great Financial Crisis started, monetary easing continues with no end in sight to the global trend. We have to ask ourselves: Is further easing actually required? What are the major costs associated with the current stance in monetary policy? Has monetary policy become too loose? There is no doubt that global economic growth continues to be lacklustre. Data in the developed world edged down in the last months of 2015 and first months of this year, following turbulence in emerging markets last summer. Our own

2 forecasting tools suggest that economic growth is, nevertheless, likely to be at around potential in the developed world (i.e. slightly below 2 % in the US and slightly above 1 % in the euro area in real terms). We have also received the first tentative positive economic data out of emerging markets, including China. Even more importantly, capital outflows from emerging markets, which were massive in the summer of last year and at the root of the sharp rise in volatility in capital markets, have lost momentum or probably stopped. As central banks in the West have repeatedly highlighted potential spill-over effects from emerging markets (read China) to their respective economies, any improvement in economic data in emerging markets may actually relieve some of the pressure to further ease or to postpone the process of policy normalisation. This is particularly true for the Fed, which has been most explicit in pointing to the importance of international developments for its own rate decision making. Inflation: Less bleak than at the beginning of the year. Moreover, the most recent stimulus measures by the ECB, BoJ and Riksbank did not manage to weaken the Euro, Yen nor Krona respectively. On the contrary, all three currencies appreciated further. Markets seem to have lost faith in the magic power of central banks to stimulate growth as the effect of more policy easing has been offset by a beggar-thy-neighbour policy of other central banks. There are more reasons to believe that monetary policy by central banks may have become too loose in the developed major world. If growth weakness relative to the pre-crisis period is less a reflection of deficient aggregate demand but rather of weak aggregate supply, as indicated above, the power of monetary policy is limited. For sure, monetary policy can help stimulate investment activity, but this alone does not guarantee a rise in potential growth rates. It certainly has to be accompanied by structural reforms, which enhance productivity as well as labour growth via rising labour participation or immigration. Financial Instability Risks on the Horizons? Inflation data, too, look less bleak than at the beginning of the year. Thanks to the rise in oil prices the key driver for headline inflation in the near term inflation rates have started to increase to a global average of 1.8 %. Core inflation, while marginally down since January of this year, is still hovering at around 2 % globally and at around the highest level since the beginning of the decade, despite lower GDP compared to before the crisis. Following years of too little investment activity in the developed world, notably in research and development (R&D), productivity growth has come down and, consequently, potential growth rates are lower than before the Global Financial Crisis. Therefore, output gaps have started to narrow (or are closed already) and core inflation rates are edging up, even though economic activity remains disappointing compared to before Admittedly, long-term inflation expectations measured by surveys have edged down during the last couple of years. Still, both in the US as well as in Europe, they remain at around the target levels of central banks. This is important because if prices were expected to fall, consumers and companies would be inclined to postpone spending, thereby driving down demand in the economy. In sum, economic activity and inflation dynamics, while far from splendid, do not necessarily suggest that more monetary stimulus is warranted. We think there is scope to continue the process of policy normalisation. In addition, ultra-easy monetary policy for too long may actually increase financial instability risks, be it by weakening the banking sector or by facilitating the formation of credit bubbles. The banking sector can suffer from ultra-easy monetary policy in two ways which are interrelated: Firstly, if the yield curve flattens substantially as a consequence of bond purchases by central banks, banks profitability suffers, thereby hampering their ability to lend. Indeed, the net interest margin of US and European banks has steadily declined over the past couple of years. Secondly, negative central bank deposit rates, currently in place in countries representing around one quarter of world GDP, are particularly detrimental to a banking system which largely depends on retail deposits. For political reasons, passing on negative deposit rates for reserves held at the central bank to retail customers by cutting interest rates on deposits into negative territory, is not a viable option. Consequently, negative deposit rates simply drive up banks costs and reduce profitability. As the ECB s most recent lending survey shows, negative interest rates will indeed become a serious concern for the banking system in the euro area if the current rate environment persists for much longer.

3 Ultra-easy monetary policy may in itself also feed new excessive credit booms. With capital mobility having risen substantially since the 1990s global capital account openness has increased significantly since the 1980s, as revealed by the Chinn-Ito index loose monetary policy is and has actually been exported to the rest of the world. Easy monetary policy by major central banks may actually be conducive to strong credit growth outside its own jurisdiction. We have indeed observed a sharp rise in non-financial credit post 2008 and the massive response by the Fed, ECB and BoE in the emerging world as well as in developed countries little or not at all affected by the Great Financial Crisis in the first place. Chart 1: Increasing incidence of financial crises and asset bubbles since the end of Bretton-Woods 60% 50% 40% 30% 20% 10% 0% 10,000 1, % of DM in crisis % of EM in crisis int. monetary system regime change S&P 500, rhs Sources: AllianzGI, Datastream. M.Schularick and A.Taylor (2009): Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crisis, ; L.Laeven and F.Valencia:, IMF WP/08/224 Systemic Banking Crisis Database ; definition of crisis years according to Schularick/Taylor ( ) and Laeven / Valencia ( ) ; own estimates for years since 2008 DM: G7, Australia, Sweden, Norway, Denmark, Spain; EM: BRICS, Turkey, Poland, Hungary, Turkey, Israel, Kuwait, Hong Kong, Singapore, Thailand, Philippines, Indonesia, Korea, Malaysia, Mexico, Argentina, Chile Leverage in the non-financial sector has reached new all-time highs and now stands at more than 230 % of world GDP with the private sector in emerging markets, especially in China, being the main culprit. We estimate that non-financial private debt in China has risen to more than 2 times GDP. This number compares to 1.6 times GDP for the average of advanced economies just before the Global Financial Crisis. It is not only the level of debt which is worrisome, but also the pace of its build-up. The credit gap, defined as the deviation of private sector leverage from trend, has reached double-digit levels in several economies, notably China, Brazil, Turkey, Hong Kong and Singapore. As history shows, all major crises since the break-up of the Bretton-Woods system, be it the Great Financial Crisis of 2007 / 08, the Asian crisis of 1997 / 98, the Tequila crisis in 1994 / 95 in Mexico (as well as in other Latin American countries) or the crisis in the Nordic countries around 1990 had been preceded by similarly wide credit gaps. In the US, too, debt levels in the non-financial corporate sector have increased substantially since the beginning of this decade, by up to almost 100 % according to bottom-up data for listed companies! This is not to say that a new financial crash is around the corner. In particular, China, with currency reserves in excess of 3 trillion US Dollars, has the means to fend off any major disruptions in the financial system. However, it suggests that credit growth has been too strong in large parts of the world, notably in emerging markets, weighing on the trend growth outlook going forward as banks may have to increase provisioning. Can these developments be linked to the post-global Financial Crisis (GFC) easing? Clearly, it is impossible to track money flows and establish watertight causal relationships between the monetary policy stance in the developed world and credit growth elsewhere. What we do know, though, is that over the last almost 30 years, major central banks policy rates have been, more often than not, below what we calculate to be a neutral level, as derived from trend nominal GDP growth. Furthermore, US monetary conditions, as measured by the Chicago Fed Monetary Conditions Indicator, have been very favourable. Additionally, the last thirty years have not only been characterised by solid economic activity real global GDP growth having averaged 3.5 % since the mid 1980s but also by the rising incidence of worldwide credit booms turning into busts. One can make the argument that too easy monetary and financial conditions for too long increase the risk of fueling credit bubbles in the medium to long term.

4 Chart 2: Central bank rates vs neutral level ( =rates relative trend nominal GDP) USA EMU JAP UK Source: Thomson Reuters Datastream, AllianzGI Economics & Strategy 27/04/2016 Understand. Act. What are the implications for investors today? While easy monetary policy has generally provided a positive backdrop for economic growth and risky assets, notably right after the financial crisis, too much easing for too long also comes at a cost. We therefore should also take any further potential stimulus measures with a pinch of salt. For asset prices to rise, it takes more than just a monetary stimulus. Reasonable valuations, which we find, for instance, in European equities as well as in emerging market assets in general, a regular income stream an argument in favour of dividend strategies and selective spread products and a solid and stable growth outlook are more important in the long run. In addition, risk management has to become an integral part of superior asset management solutions in order to address the rising probability of higher market volatility ahead. Imprint Allianz Global Investors GmbH Bockenheimer Landstr Frankfurt am Main Global Capital Markets & Thematic Research Hans-Jörg Naumer (hjn), Ann-Katrin Petersen (akp), Stefan Scheurer (st) Allianz Global Investors Data origin if not otherwise noted: Thomson Financial Datastream. Calendar date of data if not otherwise noted: May 2016

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