Monday, June 2, 2014

Central banking 2.0: Smart bombs over carpet bombs

The global markets are waiting for the ECB to make its announcement on Thursday about what steps it might take to avoid deflation. With deflation creeping into Germany and Markit M-PMI weakening, some sort of action is baked in.

As we wait, I wanted to highlight a trend in central banking to which I have seen little discussion, There has been a subtle shift from the old shock-and-awe quantitative easing approach of carpet bombing the economy with liquidity from 50,000 feet to using a more targeted approach to stimulus. Instead of carpet bombing, central bankers are now trying to find “smart bombs“ to find their targets.

As an example, the BOE and ECB published a joint discussion paper that proposed a broad number of measures to revive the loan securitization market. For more color, the FT recently highlighted Mario Draghi`s comments about trying to stimulate SME lending through securitization (emphasis added):
During the ECB’s forum on central banking which is taking place in the Portuguese town of Sintra, president Mario Draghi took the opportunity to discuss his views on how to breath new life into the eurozone’s market for securitisation.

Mr Draghi reiterated that reviving this market would depend “first and foremost” on relaxing what the ECB sees as overly onerous regulatory rules (more on which here and here).

The ECB hopes restarting securitisation will help spur lending to credit-starved smaller businesses, which Mr Draghi said provide four in every five eurozone jobs.
Draghi went on to justify his reasoning behind the push for more SME stimulus:
The ECB president also supported the Peterson Institute’s Adam Posen, who said this morning that the central bank had to do something to boost lending to SMEs at a time when the financial system was so impaired that such businesses could only borrow at overly punitive rates, if at all.

Impairment of lending to SMEs is an impairment in the transmission of monetary policy,” Mr Draghi said.
Reuters reports a possible advance announcement of an LTRO style program for lending to SME (emphasis added):
The European Central Bank is considering a new long-term liquidity operation available only to banks that agree to use the funding to lend to businesses, a German newspaper reported on Wednesday, citing sources...

But this time, an option under consideration is that the banks would have access to funding via the LTRO only if they agree to pass on the money in loans to industrial, retail and services businesses, Sueddeutsche Zeitung reported on Wednesday.

The Chinese are doing it too
The Chinese are doing it too. Instead of massively expanding the PBoC balance sheet, which the Chinese were masters of in the wake of the global financial crisis, the new leadership is trying a new policy of limited and targeted stimulus. On the weekend, this Bloomberg report indicated that the PBoC is lowering the RRR for certain rural banks:
China said it will cut the reserve requirement ratio for some of the nation’s banks, the government’s latest step to support growth in the world’s second-biggest economy.

Policy makers will “appropriately” lower the reserve requirement for banks that have extended a certain amount of loans to rural borrowers and smaller companies, the cabinet said yesterday after a regular meeting led by Premier Li Keqiang. It didn’t give more details about the reduction. The State Council also pledged to fine-tune policy when needed, while reiterating it will maintain a prudent monetary stance.
Apparently, they did not like the credit bubble creation as a side-effect of the massive stimulus unleashed in the wake of the Lehman Crisis:
The Communist Party is trying to revive the economy without repeating the mistakes of its $586 billion stimulus begun in 2008, which caused a record buildup of debt and inflated property bubbles. President Xi Jinping said this month that the nation needs to adapt to a “new normal” in the pace of growth.
For a more nuanced view, FT Alphaville pointed to a Standard Chartered research report which discussed the possible steps that Beijing might take in order to keep the economy from crashing:
The front page of this morning’s [being the 28th] China Securities News (CSN) makes for fascinating reading. In an editorial, the newspaper – which is overseen by the central bank – lays out ideas for how China might conduct monetary easing. It says that in the future, “the relevant departments might take measures including”:
  • More “re-lending” by the People’s Bank of China (PBoC) to banks, and a possible cut in official re-lending rates
  • “Targeted” RRR cuts, for instance for banks operating in central and western China
  • PBoC buying of bonds issued by the Ministry of Finance, or by entities building railways and social housing
  • Easing of banks’ loan-deposit ratios (LDRs) in some areas
The conclusion:
It appears that China’s powers that be have settled on a strategy of stimulating some parts of the economy and stifling others. A more targeted, if not insignificant, easing is apparently in effect. It may be stating the obvious but it’s always worth remembering that China’s top leaders don’t always agree and even the most powerful have been constrained — Deng Xiaoping had a cautious planner in Chen Yun to constrain him and according to some notes in our inbox what is happening in China is more of a feudal retrenchment than any real reform process. Maybe so. Maybe not.

Does the Fed follow suit?
There are some preliminary signs that the Federal Reserve is starting to seek ways of targeting monetary stimulus, as the entire tapering discussion showed that it is sick and tired of QE and wants to wind down the program.

Janet Yellen provided some hints in a speech on March 31, 2014. While many analysts believed her remarks to be dovish, I read it as a more nuanced interpretation of the US employment picture instead of the more typical academic approach of monitoring statistics, which are mainly averages, without delving into the underlying distribution which led to the averages. In that speech, Yellen pointed to the following sources of slack in the economy:
  • The high number of part-time workers who would like a full-time job;
  • The lack of wage pressure;
  • The high level of long-term unemployed workers; and
  • The falling participation rate, which she interpreted as partly caused by discouraged workers leaving the work force.
Despite her reputation as a dove, Janet Yellen has shown that she is well aware of the dangers of runaway inflation. In a speech on April 11, 2011, she stated:
While I continue to anticipate a gradual economic recovery in the context of price stability, I do recognize that further large and persistent increases in commodity prices could pose significant risks to both inflation and real activity that could necessitate a policy response. The FOMC is determined to ensure that we never again repeat the experience of the late 1960s and 1970s, when the Federal Reserve did not respond forcefully enough to rising inflation and allowed longer-term inflation expectations to drift upward. Consequently, we are paying close attention to the evolution of inflation and inflation expectations.
At this point, I am only speculating, but Yellen's March 31, 2014 speech about the shortfalls of standard employment statistics highlights her concerns about the uneven nature of the economic recovery. A recent Dallas Fed study showed that middle-skill jobs have not recovered as fast as low and high skill jobs, which by implication is leading to a hollowing out of the middle class.

Indeed, Bespoke recently illustrated the bifurcation of the recovery by showing the consumer confidence gap between the well-off and the not so well-off:

In the past few months, we have seen a regime change at the Fed. It's not just the chair, but the level of turnover at the board level. The new vice chair, Stanley Fischer, has shown himself to be both a highly effective and pragmatic central banker (see A new direction at the Yellen Fed).

If the Yellen Fed were to shift from the old carpet bombing QE tactics of flooding the system with liquidity to a more targeted approach of finding “smart bombs“ to achieve their goals, it would indeed be good news. After all, all the other kids on the block are doing it too, why not the Fed?

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

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