Is Currency Depreciation the Last Tool Left?

The Reserve Bank of Australia follows the commendable practice of scattering what it calls boxes throughout the main text of its regular reports on monetary policy.

These break out boxes focus on particular, often highly significant developments in current policy formulation.

In its latest publication the RBA has published a box bearing the description: “The Decline in Bond Yields and Inflation Expectations”.

Hardly arresting, but these issues are destined to determine global economic performance through 2015 and beyond. Note the word, ‘global’.

Before the global financial crisis these were policy areas regulated by country-based central bankers. The general modus operandi was to deliver a stable platform for marketbased economic activity by targeting the inflation rate and anchoring expectations of price movements.

But what has happened with the GFC is that external developments now more frequently and directly override domestic economic and political policy formulation.

Compounding the implications of this restructuring is the uncomfortable fact that there are widespread differences of opinion about the content and timing of prospective policy changes.

Central bankers have extended their powers and influence to an extent unimagined before the GFC.

A tricky explanation

Ironically their embrace of unconventional policies such as quantitative easing has undermined the reliability of their tools of trade; namely modeling the interplay of economic forces for the purpose of deriving a policy framework that would deliver the targeted inflation rate.

Bond yields that reflect the views of the market place occupy an important role in this process.

However, few if any economic models would have forecast the upheaval that has occurred in the yields on bonds issued by the governments of developed economies in recent months.

According to the RBA around US$7.6 trillion, or almost one quarter of developed markets’ sovereign debt has recently traded with yields at or below zero. This includes almost half of Japanese sovereign debt and about two thirds of German sovereign debt.

“While the magnitude of these falls in sovereign bond yields is,” the bank says, “difficult to explain, the declines reflect developments in both supply and demand for such securities.”

On the supply side we are told that falling fiscal deficits will be cutting back issuance, with Germany issuing only E26 billion of new debt in 2015 compared with E50 billion five years ago. That’s about 0.3 per cent of the US$7.6 trillion traded in recent months. One feels there’s more than a touch of insouciance in the Reserve’s attitude to money. Grubby stuff. 

Unclear expectations

One important, if worrying, morsel was the bank’s explanation for the lift in the demand side for the leveraged yield bonds.

It was: “Yields on medium-term bonds in Europe and other economies have also been depressed by growing expectations that policy rates in these economies will remain close to zero for an extended period.”

Inflation expectations are you might think, conceptually more easily understood than sovereign debt being bought and sold in vast volumes at prices below their face value.

Not so.

The bank has two data streams. The first is the level of inflation compensation incorporated in the price of a nominal bond. These bonds have seen their compensation element fall sharply since mid 2014.

The second measure of inflation expectations is based on surveys conducted with market participants, economists and households.

These measures have not been moving together as they have in the past.

The bank appears to favour the survey approach to the compensation one.

But it concludes: “ Unfortunately, it is not possible to accurately disentangle these two components with available data and so it is not entirely clear why bond yields have fallen to the extent they have.”

Pointing the finger

While each has recessionary implications the RBA did not provide any indication of what these were and what they thought about them.

Even allowing for space limitations, the Reserve’s survey of the decline in bond yields and inflation expectations was notable for the paucity of hard information and educated insights.

It is apparent that even with the improved news coming out of the US, these two metrics; negative bond yields and inflation expectations, signal that we have entered into a new phase of GFC.

Some 14 countries including the eurozone have cut their interest rates in the last year. China and South Korea have cut the reserve requirement ratio of the banks, a policy that David Woo, Bank of America’s London based foreign exchange analyst was reported this week as saying: “There is a growing consensus in the market that an unspoken currency war has broken out. For many countries facing zero interest rates and binding fiscal constraints, the only policy tool left at their disposal to stimulate growth is a weaker exchange rate.”

Woo said: “Of course, respectable central bankers would still insist that currency depreciation is a consequence of their monetary easing rather than a goal in itself. However, evidence suggests otherwise.”

Bill White, former chief economist at the Bank of International Settlements, has a slightly different take with the same conclusion. He sees quantitative easing as a disguised form of competitive devaluation.

He said: “The Japanese are now doing it as well but nobody can complain because the US started it.”

Regardless of whom the finger is pointed at - the greatest fear should there be a full-blooded currency war - is that China, with its inventory of excess industrial capacity, could export deflation around the globe.

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