Economist Insights Quantitative teasing - UBS

Asset management

22 July 2013

Economist Insights Quantitative teasing Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management [email protected]

Markets may feel they are being teased by the will-theywon’t-they of central bank QE decisions. In this week’s piece, we provide seven pieces of relationship advice for markets and central banks during these turbulent times. The markets need to learn to see monetary policy from the central bank’s perspective, not just their own perspective.

Gianluca Moretti Fixed Income Economist UBS Global Asset Management [email protected]

They pledged eternal love (well, QE-ternity), but then threatened to take it all away (tapering) while promising they would still be friends (rates on hold). When markets are being teased like this, it is no wonder they are confused about their relationship with central banks. For this relationship, economists are the ‘agony aunts’ so here are seven pieces of relationship advice for the markets during these turbulent times. 1. “Think about what your partner wants, not what you want from your partner.” The market craves certainty; it is a very needy partner that way. Central banks want to do the right thing for the economy, so they need the flexibility to react to the data as it changes. The two demands are mutually exclusive, so the market will always be disappointed with the amount of certainty that central banks can provide. 2. “Don’t over-interpret every little thing they do.” This follows on from the first piece of advice. The market dissects every statement and pores over every speech to look for clues that will provide the certainty about monetary policy that they so desire. Unfortunately, that certainty does not exist. To add to the problem, central banks are partners with multiple personalities: the messages vary with the speaker. 3. “Commitment is a big step – don’t ask for too much too quickly.” At times, a central bank will be willing to make some commitment to provide at least a bit of conviction if not

absolute certainty. Forward guidance on interest rates is a form of commitment, but a central bank will always leave wiggle room to change its mind if developments change. In the last few weeks, Chairman Bernanke has made it abundantly clear that the 6.5% unemployment rate in the US Federal Reserve’s forward guidance is a threshold, not a target. Even though he is unlikely to be Fed Chairman at the time, he clearly expects the Fed to let the unemployment rate go right through that threshold and even lower. The Bank of England has not yet adopted forward guidance, but its thresholds will likely be flexible as well. Talking down the relationship Implied increase in interest rates by Q4 2014 0.75

0.50

0.25

0.00

-0.25 Jan

Feb

Federal Reserve

Mar

Apr

May

Bank of England

Source: Bloomberg, UBS Global Asset Management

Jun

Jul

4. “Remember that there is more than one way to express affection.” As soon as the Fed announced the possibility of tapering, the market thought that the days of easy policy were over. To the market, tapering means a more optimistic Fed which means earlier rate hikes. In fact, the opposite is more likely to be true. QE is a very uncertain tool. Dovish central bankers are worried that extra QE may have little impact, while hawkish central bankers are worried about potential side effects (see below). This creates a consensus for less QE as long as a decent substitute can be found. Most doves would be happy for more extended forward guidance (lower for longer) because they are more confident about the benefits of forward guidance. Most hawks are less worried about the side effects of forward guidance than of QE. This means that early tapering could actually mean later interest rate hikes. Note how keen the Fed has been to stress the difference between tapering and rate hikes, and also how the doves in the Bank of England did not vote for QE but only because they preferred a different ‘mix’ of support for the economy. Recently, the market has started to understand the distinction and is pricing in later rate hikes (see chart). 5. “Sometimes you have to be cruel to be kind.” This is actually advice for the central banks, but it will be better for the markets if they understand that central banks sometimes have to be the bad guy. A number of central bankers have been worrying about the possibility of bubbles generated by excessive liquidity. Some are worried that this liquidity could lead to investors underestimating risks in general. For these central bankers, a painful but necessary reminder that liquidity can go the other way was required, and the talk of tapering by the Fed provided just such a reminder (as anyone who was holding a lot of government bonds in early May could tell you).

6. “Don’t push them too hard – they may push back.” Markets act as if their reaction can be completely independent of what central banks do: the central bank acts, the market reacts, and that’s that. The relationship is actually more reciprocal than that. Central banks do not target the short rate and the quantity of money purely for the sake of it. They use these as instruments to change borrowing costs and returns on savings: in short, central banks are really targeting the yield curve. If the market reacts to prospective tapering or tightening by pushing yields up too much, this will constitute a tightening of financial conditions. That will then slow growth, which means that the central bank will actually have to further loosen monetary policy. This can be a very volatile process but the market should not forget that ultimately the central bank will react to sharp increases in yields. 7. “Don’t take them for granted.” The central banks that people thought they knew well six years ago are no more. So many pre-crisis taboos of central banking have been broken that the really clear message is that you should never underestimate what the central banks might try. Just because some of them are shifting out of easing mode does not mean that they have lost the capacity to surprise the market. At least that helps keep the relationship fresh.

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