The Federal Reserve and the ECB are in very different positions: the former has more room to ease policy and it is also closer to its policy targets. The ECB has limited remaining policy leeway but is confronted with an inflation shortfall versus its aim and a risk that this gap would increase, rather than narrow. These differences have led to diverging approaches in the conduct of and communication about monetary policy. The Fed is data-dependent and, except for the projections of the FOMC members, offers no guidance. The ECB is agnostic about the data and builds its communication around state-dependent forward guidance: policy tightening will be solely conditioned by meeting its target
External liquidity is comfortable even though the recent years have been less favourable for external asset accumulation. Years of very high current account surpluses (almost 20% of GDP on average during 2005-2014) have resulted in a high level of FX assets at the central bank. In the short term, SAMA[1] FX assets are expected to decline for two reasons: More than a third of reserves (USD 181 bn in 2018) are government assets used to finance part of the fiscal deficit. The decline in oil production linked to the strike on oil facilities (September 14th) should turn the current account surplus into deficit (0.4% of GDP in 2019). At end-2019, SAMA FX reserves should reach around USD 470 bn (24 months of imports of goods & services)
The ECB delivered a strong message. The eurozone monetary authorities announced the implementation of a new series of monetary easing measures that went beyond expectations. The Frankfurt-based central bank largely wielded its policy tools by strengthening forward guidance, lowering the deposit rate, easing long-term lending conditions for banks and reactivating net securities purchases. Although the effectiveness of such measures remains uncertain, the ECB’s proactive approach was welcomed. Aware that certain policies could have some perverse effects, the central bankers are now demanding that governments use fiscal policy to pick up the slack for quite some time to come.
Market expectations were elevated but the Governing Council did not disappoint. The comprehensive nature of the package, with the introduction of state-dependent forward guidance, take away the need to envisage additional measures in the foreseeable future. ECB watching has been narrowed to monitoring the gap between inflation and the ECB target. Given certain negative side effects of the current monetary mix, which are acknowledged by the Governing Council, fiscal policy, where leeway is available, is now requested to step up to the plate, so as to foster growth and speed up convergence of inflation to target. The policy baton has been passed.
The Governing Council has tasked Eurosystem committees to examine its monetary policy options. Given the insistence on its determination to act, Thursday’s meeting outcome was basically a pre-announcement of easing in September. Being aware of the importance of maintaining the ECB’s inflation targeting credibility, Mario Draghi was very explicit in expressing his dissatisfaction with current inflation and its outlook, adding that a highly accomodative monetary policy is here to stay for a long period of time.
Fed Chairman Powell, in his address to Congress this week, has confirmed that easing is coming. In June, ECB President Draghi provided similar hints. This comes on the back of growing concerns regarding global growth and ultimately facing too low a level of inflation. Risks may be mounting, but, on the other hand, the unemployment rate is close to the natural rate. There are reasons to assume that monetary easing under full employment would be less effective than when the economy is marred in recession. Monetary easing could also raise concerns about financial stability, which, if unaddressed, could weigh on the ability of monetary policy to successfully boost inflation.
ECB President Mario Draghi, speaking at Sintra, has raised expectations of renewed policy easing.The message from the FOMC meeting is that rate cuts are coming. This policy synchronisation reflects shared issues (inflation too low versus target) and shared concerns, the major being rising uncertainty. Should this continue, the effectiveness of monetary accomodation will suffer.
Interest rates on US federal government debt have declined significantly in recent months. With the yield on 10-year Treasuries at 2.1%, the Federal government’s cost of borrowing has fallen to the lowest level since September 2017. President Donald Trump is bound to be pleased. The supremacy of the dollar offers him the privilege of being able to widen the deficit almost endlessly, at a time when the appetite for US Treasuries seems to be inexhaustible. Yet the stronger demand for Treasuries is also a warning signal: it indicates that investors are seeking safe havens as they form more cautious expectations. In the United States, the decline in yields is also a faithful indicator of a deterioration in the business climate.
After a precipitous 42% decline against a euro-dollar average between January and August 2018, half of which occurred in the month of August alone, the Turkish lira (TRY) rebounded by 15% in September-December, following a massive interest rate hike by the Turkish central bank (CBRT). Nonetheless, the TRY has depreciated again by 10% over the past two months amid stagflation. FX volatility has spiked owing to uncertainty about the true level of “free” FX reserves. Net outflows of non-resident portfolio investment in local currency amounted to USD 1.4 bn in March-April as non-resident investors pulled out of the local equity market and, above all, the local bond market. They now hold only 12% of domestic public debt (vs. more than 20% through 2014).
Since 20 March, American banks have been making overnight transactions with base money at higher rates than the US Federal Reserve pays on their current accounts. At a time of abundant central bank reserves (compared to pre-crisis standards), this unusual structure for money market rates comes as a surprise. This rate structure reflects the tensions on central bank liquidity over the past year, in terms of both demand (driven up by new liquidity requirements) and supply (squeezed by a more attractive repo market). Without an intensification of transactions in the interbank market, the Fed is unlikely to change its decision to continue reducing its balance sheet through the end of September
The ECB sharply lowered its 2019 growth forecast. Inflation is also expected to be milder over the entire forecast horizon. ECB president Mario Draghi noted that uncertainty was particularly high, but said that the vibrant labour market was supporting economic activity. Key rates would not be raised in 2019. Another round of targeted longer-term refinancing operations (TLTRO), with a maturity of 2 years each, would be launched starting in September 2019 and ending in March 2021.
The Federal Reserve will conduct a review of its monetary policy framework and the conclusions will be made public in the first half of 2020. Three questions will be addressed: should the monetary policy stance take into account past misses of the inflation objective? Are the tools adequate? How can communication be improved? The initiative should be welcomed because it shows the Fed’s efforts for being ready when the next recession hits. Facing similar challenges, the ECB is likely to be interested in the outcome of the Fed research.
In the eurozone, money market rates have been holding in negative territory for more than four years. The highest-rated government and corporate bonds are still yielding less than 1%. The distribution of interest rates around the zero lower bound was initially seen as an exceptional crisis adjustment mechanism, but the situation persists. Some expect this exceptional period to finally come to a close once the European Central Bank halts its net securities purchases and possibly begins to raise key rates after summer 2019. For others, the situation has definitively changed: a bit like Japan, the diminution of eurozone interest rates marks the erosion of growth potential and the quasi-elimination of inflation
Annual flows of household savings into cash and deposits on the one hand (primarily sight deposits, passbook savings accounts and homebuyer savings plans), and life insurance products on the other are evolving in opposite directions. In an environment of low opportunity cost of holding banking deposits, nets flows towards savings deposits have surpassed those towards life insurance and retirement savings since third-quarter 2016. They have begun to come together again since the second half of 2017: the net collection of life insurance products has increased slightly while inflows of savings deposits have eased. Unit-linked contracts are the exclusive beneficiary of this trend and their gross inflow1 reached in 2018 its highest level since 2000
In 2014, the Securities and Exchange Commission (SEC) adopted reforms to limit the scope of US constant net asset value money market funds. Money market funds that until then were invested in private debt (prime funds) had to abandon this model while funds that were invested in public debt (government funds) retained the ability to provide a guarantee to investors that they would recover all of their original investment*. Starting in October 2015, the reforms have led to a massive reallocation of cash from prime funds to government funds. Foreign banks, traditional borrowers of prime funds, were deprived access to US dollars while the US Treasury and federal agencies attracted fund inflows. Part of these fund inflows has been lent to US banks
