Central Banks Continue to Prepare for Shift in Fed Policy

Monetary Policy Week in Review: Jul 21-25, 2014

by Peter Nielsen, Central Bank News

Central banks are continuing to position themselves to weather the fallout from the coming shift in U.S. monetary policy, with Hungary, Nigeria and Russia’s last week citing the need to maintain tight policy in light of the risks they will face from higher U.S. interest rates.

The strong reaction of global financial markets to news last summer that the Fed was likely to start wrapping up five years of quantitative easing – an episode now known as “taper tantrum” – is still seared in the memory of policymakers who are eager to avoid a repeat.

With the Fed’s third round of asset purchases set to conclude in November and the first rate rise expected in mid-2015, emerging market central banks want to ensure that they can offer attractive rates of return that reflect their inflation rates and the risk of exchange rate depreciation.

Russia’s central bank, which last week surprised markets by raising its rate by 50 basis points, pointed to the growing likelihood of an acceleration in inflation from what it described as “negative trends,” including “adjustments in the monetary policy of foreign central banks and the potential impact of those factors on the national currency exchange rate.”

Nigeria’s central bank, which maintained rates as expected, referred to “pressure points” that include the implications of the Fed’s tapering of quantitative easing on capital inflows and reserves.

Hungary’s central bank, which said a two-year cycle of rate cuts had now come to an end, cited the need for “a cautious approach” to policy due to the uncertainty about the future global financial environment.

New Zealand’s central bank also called for a pause after four consecutive rate rises to assess the impact of its tighter policy on the economy. But this move was widely expected due to the continued strength of its currency despite lower commodity prices.

Meanwhile, policymakers are continuing to digest and discuss the implications of last month’s annual report by the Bank for International Settlements (BIS), which called attention to the growing risks from the build-up of debt, not only in advanced economies but also in emerging markets.

The latest occasion was on Thursday, when Olivier Blanchard, economic counsellor and head of research at the International Monetary Fund (IMF), said he was less worried about the consequence of excessive risk taking in a low-yield environment than the BIS.

Speaking to the press in connection with the update to the World Economic Outlook, Blanchard agreed that valuations in some financial markets were fairly optimistic but argued that because the leverage of some “principal actors” was not high, the impact of a fall in stock prices “would not be catastrophic in the sense of leading to bankruptcies of financial actors.“

Naturally, that sounds comforting. The only problem is that economic history never repeats itself. While leverage by major banks and investors worsened the 2007-2009 financial crises, the financial industry has changed since then and major flows of capital across borders are now in the form of portfolio flows rather than banking sector flows.

“It does not follow that future bouts of market disruptions must follow the same mechanism as in the past,” the new economic adviser to the BIS, Hyun Song Shin, told central bankers at the BIS annual meeting on June 29 in Basel, Switzerland.

Long-term investors may now respond to the same forces that leveraged players reacted to in the past. There is a higher proportion of investors with short-term time horizons in emerging market debt instruments that can amplify any shocks when global conditions deteriorate, said Shin, who has coined this “the second phase of global liquidity.“

Through the first 30 weeks of the year, the 90 central banks followed by Central Bank News have raised their policy rates 30 times, or 10.6 percent of all decisions, up from 9.3 percent of decisions by the end of the first half and 8.7 percent at the end of the first quarter.

Meanwhile, central banks have cut rates 37 times this year, or 13.1 percent of all decisions, up from 12.1 percent at the end of June and 11.9 percent at the end of the first quarter.

Central banks are thus continuing to push down policy rates to support economic activity but the trend toward higher rates is unmistakable.

Boosted by this week’s two rate rises, the global monetary policy rate (GMPR), the average nominal rate of the 90 central banks, rose to 5.55 percent from 5.53 percent at the end of June and 5.53 percent at the end of the first quarter and 5.41 percent end-2013.

LIST OF LAST WEEK’S CENTRAL BANK DECISIONS:

• Bangladesh maintains policy rate
• Hungary cuts rate 20 bps but ends 2-year easing cycle
• Nigeria maintains rate to support stable naira FX rate
• New Zealand raises rate for 4th time but will now pause
• Russia raises rate 50 bps and will raise more if needed
• Trinidad holds rate, to manage inflation expectations

OTHER STORIES LIST LAST WEEK:

• Contraction in global banking activity ends in Q1 – BIS

TABLE WITH LAST WEEK’S MONETARY POLICY DECISIONS:

This week (Week 31) eight central banks will decide on monetary policy, comprising the countries of Israel, Angola, United States, Albania, Fiji, the Philippines, the Czech Republic and Colombia. TABLE WITH THIS WEEK’S MONETARY POLICY DECISIONS:

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