John Mourmouras: Divergent monetary policies and global capital
markets
Speech by Professor John Mourmouras, Deputy Governor of the Bank of Greece, at the
session "The role of central banks today" of the XXIV International Banking Congress,
St. Petersburg, 4 June 2015.
* * *
Governors,
Ladies and Gentlemen,
It is a great pleasure for me to be here in St. Petersburg and I would like to thank the
Governor of the Bank of Russia, Elvira Nabiullina, for inviting me to this international
congress attended by distinguished representatives of the finance industry and the central
banking sector. I would like to make a few remarks on the potential financial consequences
of divergent monetary policies, which remain a dominant theme in the global financial
environment. Afterwards, I will be happy to answer any questions posed by the panel or the
floor.
1. Introduction
Global growth and inflation prospects, while not as dire as a few months ago, are far from
robust. Notwithstanding the slow steps by the Federal Reserve (Fed) towards normalisation
of monetary policy in the US, the central bank community today remains ultra-loose, with the
certainty of further stimulus in Europe and Japan in the months ahead and the likelihood of
monetary easing in China and elsewhere. The Greek debt crisis still remains pending and
there are also downside risks on the geopolitical front, even in this region (e.g. the events in
Ukraine, particularly with the Minsk II ceasefire under increasing strain). Several central
banks (including all four major, i.e. the US Federal Reserve, the ECB, the Bank of England
and the Bank of Japan) have engaged in unconventional monetary policies, including
largescale asset purchase programmes, and forward guidance about the future path of monetary
policy. We have also lately witnessed discretionary policy actions by an increasing number of
central banks with direct effects on the foreign exchange value of their currencies, naturally
raising concerns about a recourse to beggar-thy-neighbour policies and competitive
devaluations. The consensus among analysts is that a period of divergent monetary policies
among central banks will last for quite some time, giving rise to a number of important
questions to be addressed, to mention but two: (a) what are the effects and the channels of
the international transmission of monetary policy today, (b) what are the spillovers from the
policies of major central banks to the rest of the world, including emerging markets, in terms
of capital flows, bond markets and exchange rates, and if there is any scope for global
monetary policy coordination.
I propose to focus on the following three remarks. Firstly, I will discuss the ECB's ongoing
expanded asset purchase programme (QE) and its impact on the euro area economy.
Secondly, I will discuss how divergent monetary policies among the world's leading central
banks may trigger excessive volatility in global financial markets. Last but not least, I will
examine if there is any scope for global monetary policy coordination that can effectively
address the risks that lie behind "asymmetric" monetary policies.
2. Draghi's qe: an early evaluation
First of all, I will explain why it is that we talk about low inflation, rather than deflation, in the
euro area. Inflation is expected to remain very low or slightly negative in the coming months,
with an average inflation projection of 0.3% for the year 2015, against a yearly average of
0.4% in 2014. In advanced economies, the inflation rate will stand at 0.4% on a yearly basis
in 2015, according to the latest IMF forecasts, which is the lowest level in the last 30 years,
and in EMEs at 5.4%, one of the lowest in the last 20 years. Although in the euro area, there
is more than a 50% risk of the inflation rate hovering below one percent in the short-run, the
risk of deflation is quite low at less than 10% in the short term (in the next one to two years)
and effectively zero (1% risk) in the longer term (in the next five years). Despite recent
monthly inflation "dips" to negative levels there is no deflationary bias embedded in wage
contracts and consumer behaviour in the euro area, as opposed to the inflationary bias we
have experienced over the past three decades (1980s-1990s-2000s). Ultimately, the ECB
should fulfil its mandate, as the Harmonised Index of Consumer Prices (HICP) is expected to
reach 1.8% in 2017, which is consistent with the primary goal of price stability, i.e.
maintaining the euro area inflation rate below, but close to, 2% over the medium term.
Let me now quickly refer to the key features of the ECB's recent asset purchase programme
and focus mainly on the impact of QE, which judging from preliminary evidence, is really
encouraging. The key elements of the programme are the following: (a) Monthly asset
purchases will amount to €60 billion of private and sovereign debt. The programme will
amount to a total of €1.1 trillion in asset purchases carried out from March 2015 until
September 2016. (b) Loss-sharing is reserved for those purchases that are carried out by the
ECB, accounting for 20% of the total purchases. The remaining 80% of all purchases - i.e.
purchases made by NCBs - will not be subject to loss-sharing.
Since the announcement of the ECB's QE on 22 January, projections for real GDP growth in
2015 and 2016 have been revised upwards (to 1.5% and 1.9%, respectively) compared with
December 2014. Furthermore, model-based estimates indicate that market-based measures
of inflation expectations have reacted positively to the progressive expansion of the ECB's
balance sheet over the last few months and have been revised upwards, as well. As far as
financial markets are concerned, the impact of the asset purchase programme accounts for
most of the fall in euro area long-term sovereign bond yields since last December, as market
participants anticipated the ECB's QE programme. Government bonds across a wide range
of euro area countries traded at historically low, and often negative, yields. The decline was
most pronounced in the longest maturities, with yields on French and German 10-year bonds
falling by around 60 basis points, while those on Italian and Portuguese bonds of the same
maturity shrank by 70 and 90 basis points, respectively. The major European stock markets
have risen since end-2014 by about 17%. Furthermore, the euro depreciated by 11% since
last December, hitting a 12-year low against the dollar (for a more detailed assessment of the
ECB's QE, see my earlier speech at the 33rd Meeting of Central Bank Governors' Club in
Shanghai on 15 May 2015, available at: http://www.bankofgreece.gr/Pages/en/Bank/News/
Speeches/DispItem.aspx?Item_ID=317&List_ID=b2e9402e-db05-4166-9f09-e1b26a1c6f1b).
Following the ECB's accommodative monetary policy (with standard and non-standard
measures) other central banks adopted similar policies. For instance, in Europe, the Central
Bank of Denmark cut its key policy rate, taking it to the negative territory of -0.75%, while the
Central Bank of Sweden (Riksbank), with a base rate of -0.25%, has announced it will
expand its quantitative easing programme (the Riksbank pledged to buy between SKr40
billion and SKr50 billion (US $4.8-6 billion) of government bonds, taking the total stock of
Swedish sovereign debt held by the central bank to between SKr80 billion and SKr90 billion
and its share of all Swedish government debt to 15%) in an effort to stimulate the economy.
In total, from the start of the year, 22 central banks lowered their official rates (including the
Bank of Russia, which, since last December's drastic rise to 17%, lowered its interest rates
three consecutive times, the last time being in April, when rates were cut by 1.5 percentage
points to 12.5%). In light of all this, one can speak of a period of truly global monetary easing!
3. Divergent monetary policies and capital markets
Some theory
Many analysts believe that purchases by central banks are the dominant cause of low bond
yields today. Apparently, this has to be a factor since a QE programme, by its very nature, is
an extension of the intervention horizon of monetary policy and as such it has a direct impact
on long-term interest rates (the average maturity of the securities bought by the ECB under
its QE programme is 8.1 years). However, a far more important determinant of low bond
yields today is the expectation that short-term rates will stay low, which in turn reflects
expectations of low and persistent inflation and of a weak and uncertain recovery. Perhaps
theory is useful here. Theory suggests that long-term interest rates should be a weighted
average of expected short-term interest rates plus a term premium. The premium should
normally be positive, even in the absence of default risk. Longer-term securities are riskier
than short-term ones, because their prices are volatile. Expected short-term nominal rates
should be determined by expected real interest rates and expected inflation, and expected
changes in real interest rates should, in turn, be determined by the expected balance of
savings and investment. Finally, other factors, such as risk aversion also affect the prices of
long-term bonds. What do all the above suggest about the future path of yields? The sharp
rises in expected short-term interest rates and hence in long-term yields (the term structure
of interest rates in theoretical terms) are only likely to follow a strong recovery and
subsequently a sharp rise in inflation expectations (in empirical terms, historically, sovereign
bond yields and, to a lesser extent, exchange rates track nominal GDP growth rates). We are
not there yet: only with a robust recovery in Europe and a monetary policy normalisation in
the US can markets start pricing risk in a traditional manner.
The recent bond sell-off
It is true, though, that the last days of April saw the beginning of a sharp sell-off in sovereign
bonds across the euro area bond markets, leading to soaring volatility in European bond
markets, a sharp steepening in the yield curve and an appreciation of the euro. The figures
are quite spectacular as is often the case with the markets: in just 17 working days, the
global sovereign bond index lost more than €0.5 trillion of its value! This is an upward
correction in bond yields from an early overshooting of bond prices (early undershooting of
the exchange rate), which marked the first significant adjustment in European sovereign
bond markets since mid-2013 (triggered in turn by the Federal Reserve's tapering of its asset
purchases). The 10-year Bund yield increased from a historical low of 7.5 bps on 20 April to
over 80 bps by early June. As for the other euro area countries, yields in France and other
core countries increased in a similar way, while the spreads of peripheral bonds over the
Bund have narrowed. Turning to the US government bond market, and given the strong
comovement of 10-year German and US government bond yields (with a high correlation
coefficient of .80), the 10-year US Treasury yields rose substantially to reach their highest
closing levels this year in the region of 2.30%, as the contagion from the European bond
selloff was the main driver of their recent rise. Given the fact that recent US macro data were
mixed and the uncertainty surrounding the Fed's rate hike timing, there was additional
volatility in US yields spilling over to Bunds and other euro area countries, with the interest
rate differential set to remain in the region of 1.50%. In addition, the widening gap between
US and euro area interest rates is also driving US companies to issue more
eurodenominated debt as it seems cheaper in interest rate differential terms.
In short, apart from some technical conditions (e.g. shorter-dated German Bunds which
became eligible, while they were previously not, because of their negative yields, and hence
there was less need to buy longer-dated bonds and/or volatility clustering in global bond
markets, namely that volatility in itself generates further volatility), this recent bond sell-off
reveals vulnerabilities in the current low-yield/low-inflation environment and can also be
regarded as an evident financial implication of divergent monetary policies. One should not
forget that there is still another trillion left from Draghi's QE programme to be paid. Finally,
some analysts claim that an issue of macroprudential policy arises here which, as is
wellknown, addresses risks to the financial system as a whole. More precisely, the ECB's
implementation of the expanded asset purchase programme in the current juncture might
necessitate the use of existing macroprudential tools to oversee any fallout from the credit
expansion preventing or at least moderating asset market bubbles, or even the creation of
new tools, for instance to address pressures in the insurance sector as a result of the
lowyield environment in which they operate today.
Capital flows
The repercussions on the world economy of the redirection of a major central bank's
monetary policy and/or of divergent global monetary policies which sharply alter global
exchange rates, is one of the oldest questions in international monetary economics and was
posed again recently, when the Fed launched its Quantitative Easing (QE) programme. At
the time, the Governor of the Central Bank of Brazil expressed his strong dismay at the
loosening of the Fed's monetary policy and its impact on emerging countries, in the form of
large capital inflows triggering a sharp appreciation of their currencies and a decline in
exports. It is indeed quite difficult to predict the precise form of (sometimes conflicting)
spillover effects stemming from such a change in the monetary policy stance. For instance,
the Fed's Quantitative Easing 1 (QΕ1) programme was followed by capital flows out of
emerging economies (EMEs) into US Treasuries, while the second round of Quantitative
Easing (QΕ2) had the exact opposite effect. Since then, the Fed's change of tack has once
again spurred intense reactions in EMEs (see recent statements of the Reserve Bank of
India Governor): the tapering of the Fed's asset purchase programme has resulted in
massive capital flows into advanced economies and a subsequent sharp rise in interest rates
in emerging economies to prevent a sharp devaluation of their currencies (the currencies of
Brazil, South Africa and Turkey were particularly hard-hit). Their large current account
deficits are typically financed with short-term portfolio flows and in the case of Brazil and
South Africa, falling commodity prices added further pressure. Up to now, there are no clear
indications of international portfolio rebalances due to the upcoming interest rate hike by the
Fed and/or the QE programme currently implemented by the ECB.
4. Monetary policy coordination?
We have just looked into the negative spillover effects from divergent monetary policies. Of
course, a central bank's mandate is domestic, but its policy may have global implications.
Furthermore, in an international macroeconomic environment of subdued and uneven growth
and high unemployment, zero lower-bound interest rates and a tight fiscal policy stance,
certain nations may attempt to use their monetary policies - through standard or
nonstandard measures - in order to influence their exchange rate to bolster their economy and
boost employment. The question thus arises whether monetary authorities should act in a
coordinated manner during this final stage in the exit from the global crisis and at a time
when foreign exchange rates are not an official monetary policy objective in advanced
economies. ECB President Mario Draghi, answering a relevant question in an ECB
Governing Council press conference on 6 February 2014, stressed that international
monetary cooperation cannot be ruled out.
Examples of international monetary policy coordination are not rare, but Olivier Blanchard
captured reality with the caveat: "it is like the Loch Ness monster that is much discussed, but
rarely seen" (15 December 2013). As a matter of fact, a recent notable example of monetary
policy coordination among major central banks took place at the onset of the global crisis of
2008, when the world's four leading central banks (the Federal Reserve, the ECB, the Bank
of England and the Bank of Japan) took coordinated action, affirming the need to go beyond
traditional ways of conducting monetary policy in order to continue to provide liquidity to the
financial system and prevent a collapse of transactions and a global crash. Hence they
established liquidity swap arrangements with the intention to provide foreign currency funding
to the banking systems in their jurisdictions. The US Federal Reserve provided US $500
billion to other major central banks over the 2008-2010 period, while the others used liquidity
swap lines to a lesser extent. While international cooperation between central banks has
been quite common in the field of foreign exchange markets, this occasion marked the first
multilateral central bank cooperation in the money markets field, which is central to the
implementation of a central bank's monetary policy. It is worth reminding that in the past,
serious initiatives for coordinated monetary policy have been taken under the 1985 Plaza
Accord and the 1987 Louvre Accord in order to stabilise the dollar exchange rate.
If things move towards such a policy coordination, it should in my view take the following
form: i) the Fed could perhaps extend a new swap line to the central banks of EMEs, like the
swap lines it offered at the start of the global crisis (a kind of formal policy coordination),
and/or ii) a commitment on the part of the four major central banks to communicate their
monetary policies in a clear and timely manner within the context of their forward guidance
policies, as was agreed in a G20 Meeting in 2014, (a kind of informal policy coordination,
whereby major CBs are mindful of the consequences of their actions). Such forward
guidance will enable emerging economies to promptly protect themselves against sharp and
significant capital flows and develop policies to avoid exclusive dependence on speculative
capital flows which render them vulnerable to excessive volatility in the financial markets. At
the current juncture, major central banks should signal future interest rate changes in a
timely manner, without any concerns about causing market panic, otherwise investors will
continue to overborrow and this would potentially be destabilising.
All in all, in the era of globalisation and especially against the background of low and
persistent inflation today, some form of coordinated action between major central banks
should perhaps be put on the table, particularly given the fact that governments are unable to
protect themselves against central bank decisions, which trigger significant capital flows, and
the available tools to limit such capital flows are not efficient.
Thank you very much for your attention.