Central Banks: Fighting Their Own Battles

1779 words - 8 pages

More Mixed Signals from the Fed
Having spent the weekend sifting through the minutes to 18-19 March Federal Open Market Committee (FOMC) meeting, I came away with the impression that there is a chasm between policy conduct and forward guidance. The underlying rhetorical tone of the minutes was dovish: short-term interest rates will remain at low levels for a protracted period. Despite this, the impression remains that the Fed, under Chair Yellen, is more hawkish in its policy stance than anybody expected. There were repeated references in the minutes that the Fed has badly missed the mark with respect to its dual mandate, particularly achieving the 2% inflation target. Given this failure, it ...view middle of the document...

1% versus a year ago in its latest reading in February. Most FOMC participants expect inflation to rise towards the 2% target over the few years, aided by stable inflationary expectations and continued gradual economic recovery. The inflation genie is, therefore, expected to remain his bottle for a considerable period to come. If this baseline forecast is correct, and the unemployment rate continues to decline, then there appears little chance of the Fed embracing a more dovish stance. This could change, however, if inflation persistently undershoots expectations. It would be consistent with much more deep-rooted deflationary psychology than previously deemed, as well as continued lack of corporate pricing power stemming from a weak global economy. Under these circumstances, we could see the Fed shift to a more dovish stance, but only if wage inflation remained well anchored. For the time being, the bottom line on Fed policy is simple: the FOMC is quite prepared to reduce the degree of monetary accommodation, despite not achieving its dual mandate. US monetary policy has become less data dependent, at for the time being.
When Central Banking Gets Ugly
For far too many years, central bankers have been treated by the media as rock stars vis-à-vis fallible individuals. More importantly, the nexus between governments and their central banks in developed markets has become much tighter due to quantitative easing. Courtesy of financial repression, financial markets have not yet been able to challenge this closer relationship. The bond between governments and central banks has, however, come under greater scrutiny in emerging markets. What triggered the extra scrutiny? Talk of tapering by the Fed in May 2013 intensified the global battle for capital. Although tapering simply ushered in a period of less accommodation, markets initially reacted as though the Fed had already started tightening. The spotlight is now on central banks in emerging markets to adjust policy settings against a backdrop of greater risk of capital flight.
The challenge of stemming capital fight can typically be addressed by raising domestic interest rates. This option may not, however, always be available due to political constraints, such as elections. Five key emerging markets (Brazil, India, Indonesia, South Africa and Turkey) have been major beneficiaries of strong capital inflows since 2009, courtesy of quantitative easing by the Fed. With the exception of Turkey, these countries face general elections in 2014, thereby restricting the ability of their central banks to aggressively tighten policy. Even in Turkey, where there is no general election this year, the Prime Minister recently demanded that the central bank reduces its policy rate. In developed economies, such political pressure on central banks has traditionally been viewed dimly by financial markets, often incurring a credibility premium. Could things get ugly for central banks in emerging markets? Much depends on...

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