Mark Carney: Redeeming an unforgiving world
Remarks by Mr Mark Carney, Governor of the Bank of England and Chairman of the
Financial Stability Board, at the 8th Annual Institute of International Finance G20 conference,
Shanghai, 26 February 2016.
* * *
The global economy risks becoming trapped in a low growth, low inflation, low interest rate
equilibrium. For the past seven years, growth has serially disappointed - sometimes
spectacularly, as in the depths of the global financial and euro crises; more often than not
grindingly as past debts weigh on activity (Chart 1).
This underperformance is principally the product of weaker potential supply growth in virtually
all G20 economies.1 It is a reminder that demand stimulus on its own can do little to
counteract longer-term forces of demographic change and productivity growth.
Chart 1
Serial growth disappointments
Per cent
Actual GDP growth 2011 2012 2013 2014 2015
8
Dotted lines = Emerging economies
Solid lines = Advanced economies
7
6
5
4
3
2
1
0
2010 2011 2012 2013 2014 2015
Source: IMF.
That is not to suggest that such stimulus is without value or impact. Accommodative
monetary policy can support activity while parts of the economy delever. Monetary stimulus
can avoid hysteresis in the labour market. And monetary stimulus can buy time for structural
adjustments which shift activity from public to private, external to domestic, and declining to
rising sectors.
The time purchased by stimulus has been well spent fixing the fault lines which caused the
global financial crisis. Derivative markets have been made simpler and safer. Fragile shadow
banking activities are being transformed into stronger market-based finance. And the
scourge of too-big-to-fail is ending.2
Most notably, a more resilient global banking system is being built. The dog that hasn't
barked in recent months has been financial distress at the core. This means banks are
poised to dampen rather than amplify the impact on households and businesses of recent
global financial shocks.
Monetary stimulus has also made room for the repair - if not yet the completion - of
European Monetary Union. Over the past year, euro-area growth has broadened, though in
the ECB's judgment, it has not yet strengthened to a degree consistent with its price stability
objective let alone the expectations of Europe's citizens.
More fundamentally, global growth has disappointed because the innovation and ambition of
global monetary policy has not been matched by structural measures.
In most advanced economies, difficult structural reforms have been deferred. In parallel, in a
number of emerging market economies, the post-crisis period was marked by credit booms
reinforced by foreign capital inflows, which are now brutally reversing (Charts 2 and 3). The
international financial and monetary architecture has been tinkered with rather than
transformed. With the forces of fragmentation now rising in many countries, it will be more
challenging to build a truly open, global system. The consequences of such timidity are
reflected in the sizeable downside risks which currently plague the global outlook.
Chart 2
Credit booms across EMEs
Percentage points
80
2008 Q2 2014 Q1 2015 Q1
60
40
20
0
-+
20
40
60
India
Kong
Spain Africa Brazil China
Korea
States
Ireland Poland Russia Turkey
Mexico
Hungary
Kingdom
Argentina Indonesia
Singapore
Hong
South
South
United
United
Sources: BIS total credit statistics and Bank calculations.
Chart 3
EME capital flows reversing
Per cent of GDP
5
(a)
EM ex. China China
4
3
2
1
+
0
-
-1
-2
-3
-4
2000 2002 2004 2006 2008 2010 2012 2014 2016
Source: IMF.
(a) 2016 is a forecast.
These shortcomings also explain much of the sharp fall in global nominal growth since the
crisis. Since 2007, global nominal GDP growth (in dollars) has been cut in half from over 8%
to 4% last year, thereby compounding the challenges of private and public deleveraging
(Table 1). In an unforgiving global environment even those economies with resilient private
demand, like the UK, must manage policy with vigilance and dexterity.
Table 1
Global nominal growth halved since 2007
% China US Euro area UK Japan World
1998-2007
13.0 5.3 4.4 5.3 -0.2 6.5
average
2007 23.1 4.5 5.6 5.5 1.2 8.4
2013 10.1 3.1 1.0 4.2 0.8 4.9
2014 8.2 4.1 1.8 4.7 1.6 5.0
2015 (estimate) 6.5 3.4 2.8 2.6 2.5 4.0
Source: IMF and Bank calculations.
Renewed appreciation of the weak global outlook appears to have been the underlying
cause of recent market turbulence. The latest freefall in commodity prices - though largely
the product of actual and potential supply increases - has reinforced concerns about the
sluggishness of global demand. And a series of relatively small data disappointments for
many major G20 economies have added to these worries.
Necessary changes in the stance of monetary policy removed the complacent assumption
that "all bad news is good news" (because it brought renewed stimulus) that many felt
underpinned markets.
And as I will discuss in a moment, several commentators are peddling the myth that
monetary policy is "out of ammunition." Is "the only game in town" over?
As a consequence of these developments, investors are now re-considering whether the
past seven years have been well spent. Has exceptional monetary policy merely bridged two
low-growth equilibria? Or, even worse, has it been a pier, leaving the global economy facing
a global liquidity trap? Can more time be purchased? If so, at what cost and, most
importantly, how would that time be best spent?
These are the questions we should address during China's G20 Presidency. They must be
met with a response that matches the ambition and pragmatism of our hosts across financial
reform, monetary policy and structural initiatives.
Recent market turbulence
Since the start of the year, risk sentiment in financial markets has deteriorated sharply,
stemming in large part from a renewed appreciation of weak medium-term global growth
prospects accompanied by marked downside risks.
Despite a recent recovery, equity markets are still down materially since the start of the year.
Volatility has spilled over into corporate bond markets with US high-yield spreads at levels
last seen during the euro-area crisis. The default rate implied by the US high-yield CDX index
is more than double its long-run average. And sterling and US dollar investment grade
corporate bond spreads are more than 75bp higher over the past year.
On the back of these concerns, risk premia have increased across the board, with "safe
haven" assets and currencies benefitting at the expense of equities, credit and commodities.
In this 'risk off' environment, correlations across asset classes are up sharply.
Falls in market liquidity have contributed to strains in some markets. In treasuries and gilts,
spreads between 30-year yields and the equivalent swaps have risen by over 40 basis points
since the beginning of 2015. And there has been a widening in the spread between corporate
bond yields and CDS premia which may reflect a reduction in arbitrage as dealers conserve
their balance sheets.
Banking stocks have been particularly hard hit, down about a quarter on average over the
past three months, across the advanced economies, prompting some to question whether
anything has really changed (Chart 5). This re-pricing likely reflects first and foremost
renewed growth worries. Banks have always been high beta to the economy.
Rising dislocations across credit and fixed income markets
Basis points Basis points
10 5
0
-10 0
-20
-30 -5
-40
-50 -10
-60
30yr swap spread
-70 -15
CDS-cash basis
-80
IG skew (rhs)
-90 -20
Jul.14 Jul.15
Jan.14 Jan.15 Jan.16
Sep.14 Sep.15
Mar.14 Nov.14 Mar.15 Nov.15
May.14 May.15
Source: Barclays Live and Bank calculations. IG skew refers to the difference between US CDX.IG
index and single-name CDS (SNCDS), 10-year swap spread is the spread between 10-yr USD swap
and 10yr US treasury note, and CDS-cash basis is the spread between SNCDS and a basket of
equivalent cash bonds.
Chart 5
Bank equities down 25% since end 2015
UK US Euro area Japan
105
100
95
90
(Dec
85
2015
=
80
100)
75
70
65
01 17 04 20 05 23
December January February
2016
2015
Source: Thomson Reuters Datastream and Bank Calculations.
UK banks' ROE down 11pp since 2006(a)
Per cent
30
25
20
15
10
5
0
Pre-tax
-5
Post-tax
-10
-15
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
H1
Sources: Published accounts and Bank calculations.
(a) UK Banks are: Barclays, HSBC, LBG, Nationwide, RBS and Santander UK.
Table 2
Drivers of UK banks' lower ROE
Total reduction in post-tax return on equity, 2006-H1 2015(a) -11
Due to reduction in leverage -4
Due to fall in return on assets -7
of which: Net interest income -4
Trading income and fees -6
Misconduct costs -3
Other income and expenses -4
Increases due to
Impairments 3
Operating expenses 7
Sources: Published accounts, bank data submissions and Bank calculations. (a) UK banks are Barclays,
Cooperative Bank, HSBC, Lloyds Banking Group, Nationwide, RBS and Santander UK.
More fundamentally, banks are out of favour because of a new-found exasperation with their
returns rather than due to old concerns about their resilience.
UK banks, for example, have seen a sharp decline in profitability since the crisis, with
average group-level post-tax returns on equity falling from 17% in 2006 to 6% in the first half
of 2015 (Chart 6). Of course, with hindsight, a substantial proportion of the pre-crisis return
was ephemeral, reliant on short-term funding, capital-light balance sheets and massive
synthetic leverage.
Banks are facing continuing pressures on their business models from a number of sources,
including:
• The consequences of a low growth, low rates environment with ongoing private
deleveraging;
• The impact of a new regulatory framework designed to fix the fault lines that caused
the crisis; and
• The effect of determined progress on removing the implicit public subsidy of
TooBig-To-Fail.
Finally, some residual concerns about regulatory uncertainty, particularly in the euro area,
may have been secondary reinforcements to the macroeconomic drivers of recent market
turbulence.
Financial reform and the state of the financial system
However, this is not 2008.
The largest cross-border banks are considerably stronger than during prior episodes of
market stress. Common equity requirements are seven times the pre-crisis standard for most
banks. For global systemically important banks (G-SIBs), they are more than ten times
higher. Global standards require banks to hold much higher liquid asset buffers, to
strengthen their trading books, and to reduce and simplify the formerly complex web of
interbank exposures.
In response, banks have built higher and better quality capital buffers (Chart 7), largely
through retained earnings, and have reduced leverage. Between 2008 and 2015, advanced
economy G-SIBs raised close to $800bn of equity, while almost $200bn was raised by major
UK banks, over a period during which these banks' risk-weighted assets fell. It is expected
that the aggregate common equity tier one ratio across all G-SIBs, as calculated on the basis
of the fully-loaded Basel III requirements, was more than 11% at end-2015, double the ratio
in 2009. In parallel, authorities have tightened both the definition of total capital and the
requirements on trading activities.
Bank funding profiles have also improved since the crisis. For UK banks, liquid asset
holdings have tripled to £500bn and, for the system as a whole, customer loan books are
now entirely funded by customer deposits - up from around 75%. Trading assets are down
by a third and inter-bank exposures have shrunk by two thirds.
Moreover, in the United Kingdom, banks have already been stress tested to ensure they
have enough capital to cover two severe scenarios: a hard landing in emerging markets, and
a UK balance of payments shock.
Chart 7
Capital ratios up materially
% of RWA
CET1 (net of transitionals) Transitional adjustments
14
12
10
8
6
4
2
0
2008 2015 H1 2008 2015 H1 2008 2015 H1 2008 2015 H1
€A Core €A Periphery UK US
Source: SNL, EBA and Bank calculations.
Policymakers can help banks transition to more sustainable business models by giving the
maximum regulatory clarity. With the agreements reached in recent years, including Basel III
and the global agreement on Total Loss Absorbing Capacity, the overall international
regulatory and resolution framework for banks is now largely settled.
The FSB, Basel Committee and other authorities now need to build confidence about the
stability of the overall requirements, deliver transparency about the extent to which
institutions meet them, and fix some important remaining details.3
For example, the Basel Committee is continuing to work on elements of the Basel III
framework to ensure its overall coherence and maximise its effectiveness. In doing so,
authorities are focused on not significantly increasing overall capital requirements across the
banking sector.
In short, there will be no Basel IV.
Monetary policy
By making the banking system substantially stronger, financial reform has made monetary
policy more effective.
That is essential because the force of the headwinds facing monetary policy are leading
some to claim central banks are out of monetary ammunition. This is wrong, but the
widespread absence of global price pressures demands that our firepower be well aimed.
A set of powerful forces, both secular and cyclical, have depressed 'equilibrium' interest rates
globally. These forces include demographic change, slower potential growth, higher credit
spreads, lower desired investment, a lower relative price of capital, greater income inequality,
sustained private deleveraging and lower public investment.
Together these dynamics have raised desired savings and lowered desired investment. With
more savings chasing fewer investment opportunities, equilibrium safe returns have fallen
sharply towards zero (Chart 8 - see also Annex). Colleagues at the Bank of England
estimate that these factors can explain around 400 of the 450 basis points fall in global
longterm equilibrium rates since the 1980s.4 The persistence of many of these trends suggests
that the global neutral real rate could settle around 1% over the medium to long term.
Chart 8
Secular drivers pushing down on rates
Why does that matter?
Central banks must set their policy rates with regard to equilibrium interest rates in order to
maintain demand growth in line with supply growth and to stabilise inflation. Setting real
interest rates substantially above the equilibrium rate would, in time, generate rising
unemployment and falling prices. The opposite is true of setting rates substantially below the
equilibrium rate. The substantial variance of the equilibrium rate over time means that a 4%
policy rate would have been highly stimulative in 1980 but would be highly contractionary
today.
At the onset of the crisis, as households and firms sought to de-lever, the equilibrium rate fell
sharply, calling for reductions of conventional policy rates to unprecedented levels.
The necessary easing, however, went well beyond what central banks could deliver with
short rates alone. Unconventional monetary policy measures, including large-scale
purchases of government securities, were necessary to deliver effective market rates
negative enough to mitigate globally deficient demand. In the UK, forward guidance
supplemented such measures, ensuring households and firms could be confident that
interest rates would not be raised prematurely, helping to secure the nascent recovery.
Central banks have also purchased other assets - in some cases using small-scale
programmes to alleviate specific cases of market dysfunction, and, in others, larger ones to
inject greater stimulus into the economy.
By deploying a broad range of ammunition, the economy has been stimulated through a
number of channels.
Lower policy rates brought forward consumption to today from spending tomorrow - the real
interest rate channel.
The all-in costs of borrowing were lowered, boosting existing borrowers' spending power -
the cash flow channel. And lower funding costs for banks increased the availability of credit
- the credit channel.
Lower discount rates and portfolio balance effects supported asset prices - the wealth
channel.
Currencies' values fell, boosting competitiveness - the exchange rate channel.
And determined central bank action and forward guidance put a floor under inflation
expectations and bolstered sentiment - the confidence channel.
In this way, central bank actions combatted the worst global downturn since the Great
Depression.
All of these tools, and many variants of them, are still available to central banks if needed.
With their arsenal well-stocked, the real questions for global reflation are how best to deploy
these weapons and whether they will be reinforced by other policies.
Low interest real rates have bought time by bringing forward demand to today from
tomorrow.5 But, to paraphrase my predecessor, Lord King, having brought forward demand
for years, tomorrow is now yesterday (and he said that three years ago!). In other words,
most central banks need the other channels of monetary policy to work harder.
The scale of unconventional measures is impressive. Asset purchase programmes have
been extended, notably in the euro area and in Japan. The largest four central banks bought
assets worth $1.2 trillion in 2015, similar to the amounts purchased post-Lehman and during
the 2013 euro-area crisis. Adjusting for lower government debt issuance, that leaves an
unprecedented flow of net QE, with only $400bn of additional government debt sold to the
private sector, compared to $3 trillion in 2010 (Chart 9).
Chart 9
Unprecedented net QE(a)
$ bn
1,500
1,000
500
-
-500
-1,000
-1,500
-2,000
-2,500
Total central bank asset purchases
-3,000
Total gross public debt issuance
-3,500
Total net
-4,000
2009 2010 2011 2012 2013 2014 2015
Source: BoE, ECB, FRBNY, Bloomberg, Datastream and Bank calculations
(a) US, UK, euro area and Japanese QE and government debt issuance. Converted into US dollar terms using
end year exchange rates.
That volume has likely pushed down on the term premia demanded by investors when they
lend at long maturities to G4 governments, reducing the cost of borrowing for firms and
households (Chart 10). In this regard, QE works through the credit and cash flow channels.
Chart 10
Term premia compressed
3.5
%
UK US Germany
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
1999 2002 2005 2008 2011 2014
Sources: Bloomberg, Federal Reserve Bank of New York and Bank calculations.
(a) UK estimate is derived using the model described in Malik, S and Meldrum, A (2014), 'Evaluating the robustness of UK term
structure decompositions using linear regression methods', Bank of England Working Paper No. 518;
www.bankofengland.co.uk/research/Documents/workingpapers/2014/wp518.pdf . The German series is a preliminary estimate
based on the same methodology as the UK estimate.
US estimates are available from www.newyorkfed.org/research/data_indicators/term_premia.html.
However, the effect of QE on the wealth channel cannot last forever. Monetary neutrality
means real asset prices are not boosted indefinitely by such policies; their economic effects
must ultimately unwind (Chart 11).
Chart 11
QE wealth effect ultimately temporary
Source: Joyce, M, Tong, M, and Woods, R "The United Kingdom's
quantitative easing policy: design, operation and impact", Bank of
England Quarterly Bulletin, 2011, Q3.
Said differently, unless an improvement in fundamentals boosts the underlying cash flows of
these assets, real valuations will fall back. That structural policies have not boosted real
growth sufficiently is a better justification for the re-pricing in risk markets than any loss of
confidence in the power of central banks.
Central bank innovation has now extended to negative rates, with around a quarter of global
output produced in economies where policy rates are literally through the floor.6
Conceptually the more that effective policy rates can be reduced below equilibrium rates, the
better the prospects for demand to grow faster than potential supply, promoting global
reflation.
However, it is critical that stimulus measures are structured to boost domestic demand,
particularly from sectors of the economy with healthy balance sheets. There are limits to the
extent to which negative rates can achieve this.
For example, banks might not pass negative policy rates fully through to their retail
customers, shutting off the cash flow and credit channels and thereby limiting the boost to
domestic demand.7 That is associated with a commonly expressed concern that negative
rates reduce banks' profitability.
To be clear, monetary policy is conducted to achieve price stability not for the benefit of bank
shareholders.
Nonetheless, when negative rates are implemented in ways that insulate retail customers,
shutting off the cash flow and other channels that mainly affect domestic demand, while
allowing wholesale rates to adjust, their main effect is through the exchange rate channel.
From an individual country's perspective this might be an attractive route to boost activity.
But for the world as a whole, this export of excess saving and transfer of demand weakness
elsewhere is ultimately a zero sum game. Moreover, to the extent it pushes greater savings
onto the global markets, global short-term equilibrium rates would fall further, pulling the
global economy closer to a liquidity trap. At the global zero bound, there is no free lunch.8
For monetary easing to work at a global level it cannot rely on simply moving scarce demand
from one country to another. Instead policy needs to increase primarily domestic demand,
with the exchange-rate channel more a side effect that accompanies any monetary policy
action.
In any given country, a monetary expansion aimed at boosting domestic demand will tend to
reduce effective interest rates9 relative to their equilibrium level, generating an excess of
domestic investment over domestic saving that must be met with a capital inflow from
abroad.
But viewed from overseas, the corresponding capital outflow will tend to raise the short-term
equilibrium rate (Chart 12), giving conventional monetary policy overseas more traction.
In this way, the rising tide of global demand would raise all boats.
Chart 12
Smaller domestic current account (CA) surplus lifts all boats
Wider policy implications
Ultimately, for monetary policy at the zero lower bound to bridge to a better equilibrium, it
must be reinforced by other policies. That is, the low interest rate environment puts a
premium on domestic and international policy coordination. For example, lower interest rates
create space for fiscal policy to boost domestic demand directly, should it be necessary, by
lowering the financing cost faced by governments.
And it doesn't take a genius to recognise that a prolonged period of low interest rates can
lead to a build-up of vulnerabilities which could derail an expansion and deepen a
subsequent recession.
This means macroprudential policy has an increasingly important role. Rightly, the Chinese
G20 Presidency has called for G20 members to learn from each other's experience of
macroprudential management.
The IMF, FSB and BIS will therefore report to G20 Leaders ahead of the Hangzhou Summit
regarding processes to analyse systemic risks; toolkits to address vulnerabilities; and
mechanisms for domestic and international coordination.
In an increasingly integrated global financial system, this work can help identify areas where
we need to work together to keep our systems resilient. It is clear, for example, that strong
links exists between asset management in advanced economies and the debt markets relied
upon by emerging market corporates.
Where appropriate, the FSB will make policy recommendations regarding structural
vulnerabilities associated with asset management activities for public consultation before the
Hangzhou Summit. And reinforced by recent experience, the FSB's second annual report on
the effects of reforms will include a comprehensive review of the extent, drivers and likely
persistence of any reduction in market liquidity.
Whither the G20 Plan for strong, sustainable, balanced growth?
Most fundamentally, the G20 needs to use the time purchased by monetary policy to develop
a coherent and urgent approach to supply-side policies.
Gradualism in structural reforms may be promoting disinflationary expectations, while
sapping the political process of its mandate. The weakness of investment not only holds back
the supply side but also weighs on the equilibrium interest rate and further burdens monetary
policy.
At the Brisbane summit in 2014, the G20 leaders agreed an ambitious goal to lift the level of
G20 GDP by at least two per cent by 2018.
But only eighteen months on, the 2 in 5 commitments are starting to look more like the
5/2 diet.
Less than half of the measures have been implemented, and only around one third of the
promised impact on global GDP has been delivered. Moreover, whilst implementation has
lagged, the need to boost growth has increased in size and urgency. The Bank of England
projects the level of global GDP in 2018 to be over 3% below what the IMF expected at the
time of the Brisbane summit.
We need to live up to China's G20 priorities. Structural reforms with a long-term focus but a
short-term implementation horizon. Determined reform of the global architecture for
sustainable capital flows. The development of our essential macroprudential frameworks and
the implementation of our financial reform commitments to address new vulnerabilities.
These will allow monetary policies to fully bridge to a better future.
Conclusion
That future needs the arms of macro policy to operate in close concert, domestically and
internationally. Demand stimulus alone will not sustainably reflate the global economy.
Moreover, sustained low rates could strain the capacities of macroprudential policies.
At their roots, fiscal, monetary, financial and structural policies are deeply complementary,
operating through many of the same channels.
A stronger financial system can better channel savings to investment, building demand in the
short run and productivity in the long run.
Monetary stimulus is more effective if, in a deflationary environment, other policies can also
give households and firms the confidence that global reflation is in prospect.
And structural reforms can boost long-run wealth allowing monetary policy to bring forward
spending from future incomes that are real and not ephemeral.
All must recognise the imperative of avoiding the global liquidity trap.
Not to beggar-thyself via beggar-thy-neighbour.
Not to obsess over process at the expense of productivity.
But by building resilient domestic demand and sustainable cross border capital flows, we in
the G20 can redeem an unforgiving world.
Annex
Chart A1
Secular drivers of lower real rates - quantification
Source: Taken from Rachel and Smith (ibid.).