Global myth of central bank independence stands exposed
Donald J. Trump made headlines when he declared a few months ago that, were he to become El Presidente, he would kick Janet Yellen out of her perch at the top of the U.S. Federal Reserve. (OK, I’m paraphrasing — for once, Trump was not that inflammatory in his comments.)
Predictably, The Donald’s critics cried foul, pointing out that America’s central bank must remain independent from political meddling.
It’s an important principle, and it applies here at home, too.
The governor of the Bank of Canada is supposed to be independent of elected government, although Stephen Poloz has recently been highlighting the merits of dialogue between monetary and fiscal policy-makers.
The thing is, in the real world, central bank independence is a myth. Not in the political sense, but in the global sense.
Today, monetary policy-makers around the world are beholden to what’s going on beyond their borders. That means they are also beholden to one another, as the policy manoeuvres in one jurisdiction loom large over those in another.
The tactics differ, but they have this in common: they don’t seem to be working.
There’s no better illustration of this interdependency than the Fed’s decision on Wednesday to hold interest rates.
For a time after last December’s historic rate increase, it looked like Yellen and her colleagues on the Federal Open Market Committee, as stewards of pretty much the only large economy that was growing strongly, were prepared to go it alone and continue to tighten policy.
Yet the post-hike story didn’t exactly go as expected. For instance, you would normally expect yields to rise in response to rising rates. That hasn’t happened.
From Dec. 16, the day the Fed hiked, to June 14, the yield on U.S. 10-year Treasuries declined by 68 basis points. The reasons are familiar. As global instability set in through January, equities sold off and investors flew to quality — and you can’t get more quality than U.S. government bonds. On top of that, while the States was tightening, Europe and Japan were busy loosening monetary conditions, prompting a rally on the U.S. dollar and hurting the earnings outlook for American companies.
The rally on the greenback has since moderated, taking pressure off the Fed to raise rates. Yet going into this week’s meeting, the self-defined “data-driven” policy body was faced with conflicting domestic data. Retail sales have been strong, but May employment numbers disappointed by 100,000 jobs. Second-quarter GDP growth looks to come in above two per cent, but it came in at less than one per cent in Q1.
Those conflicts would suggest the central bank could go either way on monetary policy, and on balance you might expect a Fed that has forecast multiple rate hikes in 2016 to err on the side of hawkishness.
But it didn’t, and the devil in the details is, once again, uncertainty.
Leading up to the Fed’s announcement — an uncertainty factor in itself — concerns over declining oil prices and Brexit have been in play. Equities were selling off and U.S. bond prices rising.
That pushed Treasury yields earlier this week to their lowest level in more than three years.
We are now left to wonder what would have happened to yields if the Fed had raised its target rate on Wednesday.
The answer might be “not much.” In fact, you could conclude that monetary policy globally, and especially in Europe and Japan, has failed to have the intended result.
The European Central Bank’s experiment with negative interest rates has not paid off in consistently stronger growth.
In fact, it has hurt bank earnings so much they may well be a deterrent to economic growth. As well, negative rates encourage funds to flow out of the European economy and into higher-yielding instruments — like Treasuries. That pushes U.S. yields down even further.
Brexit has only complicated matters, as growing fears over Britain withdrawing from the European Union have prompted yet another flight to quality. U.S., Japanese, British (yes, British) and German bonds are considered safe havens, adding to the downward pressure on yields. Earlier this week, the yield on Germany’s 10-year debt dipped into negative territory for the first time.
Japan is in a similar situation, only worse. While the Bank of Japan has followed Europe into negative interest rates, the yen has rallied against the dollar — by 13 per cent so far this year.
Rather than stimulating spending, Japan’s negative rates seem to be scaring investors into thinking Abenomics just isn’t working.
So they buy safe-haven assets, like Japanese sovereign debt. But it’s a vicious circle: risk aversion and the corresponding rise in the currency are impeding Japan’s recovery. The last thing its economy needs right now is a strong yen.
Had Yellen raised rates, she would have been doing some of the work for Japan and Europe by making their money effectively easier. But she didn’t. She couldn’t.
One reason is Brexit, which Yellen cited in her news conference as “a decision that could have consequences for economic and financial conditions” globally, and for the U.S. economic outlook.
The Fed also lowered its expectations for both economic growth and interest rates going forward.
Now Europe and Japan will likely have to resort to even more exceptional monetary and fiscal policies. Canada — which has seen its currency strengthen against the greenback, too — may end up in the same boat.
The good news for investors is that lower rates for longer should support equity prices.
At least that’s what the textbook says. But as policy-makers struggle to stimulate, the textbook might be in need of an update.