With former French President Nicolas Sarkozy, former Federal Reserve Chairman Ben Bernanke, and former head of the Bank of England Mervin King on the program at CME Group’s Global Financial Leadership Conference on November 17, there was considerable discussion among all the participants about divergences among central bank policies. While these were off-the-record sessions, the divergent paths taken by the major central banks are clearly driving some new patterns in the foreign exchange markets.
Our own view is that while the depth and suddenness of the 2008 financial panic caught central bankers off guard, they quickly mobilized to push short-term interest rates to near zero and to add liquidity to the financial system either with emergency loans or asset purchases. That is, the Federal Reserve (Fed), European Central Bank (ECB), and Bank of Japan (BoJ) all came to the party together, all adopted zero rates together, and all fought the recession together. It is now six year later, and striking differences have emerged. The U.S. economy has lowered its unemployment rate from a peak of 10% to below 6% and is creating over 200,000 net new jobs every month. Europe is stagnant. Japan has just suffered two back-to-back quarters of declining real GDP. Interestingly, despite the differences in economic performance, inflation is very low everywhere, and central bankers worry about deflation potential.
The result of the growth differences can be seen in the policy responses. The Fed has ended its asset purchases (i.e, quantitative easing) and is now debating whether the abandon it zero rate policy. The only argument against raising rates is the low inflation rate. In Europe, the ECB is planning to expand its asset purchase program and keep rates at zero. In Japan, the BoJ recently announced a huge expansion of its quantitative easing program, making it twice as big (GDP adjusted) as the Fed’s program.
The policy and growth differences are showing up in a stronger U.S. dollar. We do have a few cautions.
Japan’s two quarters of real GDP declines were induced by the increase in the national sales tax back on April 1, 2014. We expect a small positive increase in real GDP, say 1% to 2% in the October-December quarter. Also, historically, the yen moves quickly and then gets stuck in a range. The move in late 2012 to April 2013, took the yen from below 80 per US dollar to the 100 territory. The recent move seems to be headed from 100 yen per US dollar to somewhere around 120, after which a period of range trading might take hold, especially if we are correct that the economy will start growing again.
For Europe, there are two very different risks. On the downside, the Russian/Ukraine tensions have the potential to get worse in the winter. Russia’s only real challenge to economic sanctions would be to slow down the flow of natural gas to Europe in the middle of the winter. This is not a forecast, just a risk factor, but should it occur, it would be very negative for Europe and the euro. The second risk factor is in the other direction. There is a case to be made that market participants have become too pessimistic about Europe, and with the stress tests over, the credit system may function much better in 2016 and lead to incremental improvements in economic growth.