Monetary Policy

Bottom Line: It is tempting to rush to judgment on the Russian economic crisis. Russian Finance Minister Anton Siluanov is among those declaring the currency crisis over and promising rate cuts to follow currency stability. Conversely, many market analysts have warned of an imminent, full-blown economic crisis including a credit crunch, exchange-rate-driven inflation, sky-high interest rates, and rising unemployment. Both assessments are off the mark. The reality is that these are early days in the crisis; sanctions and oil together are imposing massive economic dislocations and those costs will rise over time as sanctions bind more tightly, limiting the resilience of the Russian economy. Russia still has substantial financial buffers and economic policies that it can use to delay an economic crisis, but market pressures are likely to return sometime in 2015. A Classic Currency Crisis? Recent developments in Russia present many elements of a classic emerging-market crisis. A market selloff and loss in confidence fuels capital flight. Sharp interest-rate hikes (650 basis points) fail to stem currency depreciation (see Figure 1). Investment plunges and consumers race to get out of the currency (for example, through the purchase of durable goods). Against this backdrop, it is not surprising that growth fell in the fourth quarter by 0.5 percent over a year earlier, leading to renewed currency declines. Market forecasts of a 5 percent decline for 2015 now look optimistic. But it would be misleading to view these developments solely through a currency lens. The Russian economy was already struggling prior to the current crisis, as weak economic policies, a poor global environment, and adverse demographics undermined the promise of a strong recovery following the financial crisis. Oil has always been central to Russian economic performance, but weak fiscal policies have meant that increasingly higher oil prices were needed to keep the budget balanced. In 2014, the fiscal break-even price was around $110 per barrel, compared to estimates of $30 to $40 per barrel just a decade ago. With current oil prices around $50 per barrel, the fiscal and external shortfall is substantial and is likely to widen as the government steps in with rescue packages for companies in trouble. Even though a depreciated currency can help the budget by raising the ruble value of exports, fiscal policy looks unsustainable. The most likely trigger for a future crisis resides in the financial sector. December’s $2 billion bailout of Trust Bank, coupled with news of large and potentially open-ended support for VTB Bank and Gazprombank, highlight the rapidly escalating costs of the crisis for the financial sector as state banks and energy companies face high dollar-denominated debt payments and falling revenues. Rising bad loans, falling equity values, and soaring foreign-currency debt are devastating balance sheets. As foreign banks pull back their support, the combination of sanctions, oil prices, and rising nonperforming loans is creating a toxic mix for Russian banks. So far, a crisis has been deferred by the belief that the central bank can and will fully stand behind the banking system. If any doubt creeps in about the strength of that commitment, a run will quickly materialize. Therein lies the central challenge for the central bank. News of large or unexpected bailouts trigger renewed market pressures and risks a political backlash, but the trigger for a crisis may be more closely linked to any sense that the central bank will step back from its support for the system. Figure 1: Central Bank of Russia's (CBR) Key Rate and the Value of the Ruble Source: Central Bank of Russia.   In this environment, further central bank rate hikes are likely to be counterproductive. Capital controls look increasingly likely, even though controls in Russia usually have been ineffective. Options range from those relatively benign to markets (for example, requiring state companies to sell foreign currency holdings) to repressive constraints on private deposits. In the end, evasion is simply too easy. The government has resources: international reserves fell $121 billion last year to a still-healthy $389 billion, but the government’s willingness to spend further is uncertain. Still, Russian policymakers need to do something. Sanctions as a Force Multiplier Sanctions are a force multiplier. Western sanctions have taken away the usual buffers—such as foreign borrowing and expanding trade—that Russia relies on to insulate its economy from an oil shock. Over the past several months, Western banks have cut their relationships and pulled back on lending, creating severe domestic market pressures. The financial system has fragmented. Meanwhile, trade and investment have dropped sharply. These forces limit the capacity of the Russian economy to adjust to any shock. Russia could have weathered an oil shock or sanctions alone, but not both together. This was the argument made by President Barack Obama, who stated recently that “over time [sanctions] would make the economy of Russia sufficiently vulnerable that if and when there were disruptions with respect to the price of oil—which, inevitably, there are going to be sometime, if not this year then next year or the year after—that they’d have enormous difficulty managing it.” Another implication of sanctions is the reduced risk of contagion to the West. Unlike the 1998 Russian crisis, the fact that sanctions have caused Western financial institutions to pull back from Russia makes the West less leveraged, less interconnected, and therefore less vulnerable to contagion than was the case in 1998. It is not surprising, therefore, to see a modest reaction in U.S. markets so far, with the exception of energy companies that are affected by the global energy shock. A Russian Crisis: Are We There Yet? Measured by the severity of recent market moves, Russia is in crisis. But from a broader perspective, a comprehensive economic and financial crisis would cause a far greater degree of financial distress for the Russian people. Companies would find working capital unavailable; interest rates of 17 percent (or higher) and exchange rate depreciation would cause a spike in import prices; and capital expenditure would crater. All this would generate sharp increases in unemployment and a far greater fall in gross domestic product (GDP) than we have seen so far. We are not there yet. Ultimately, though, the test of whether a crisis materializes is as much political as economic: an upturn in inflation and a deep recession would be the real test of whether sanctions would create conditions for peace, not just a move in Russian stocks and bonds. That is because it is only now that the broader Russian public is feeling the costs of President Vladimir Putin’s policies. No doubt the searing experience with hyperinflation in 1998 still resonates with the Russian public. History also reminds us of the fragility of confidence. When crisis happens, exchange rates will move far and fast. But these are early days, and economists should mind the old dictum when it comes to financial crises: predict an outcome or a date, but not both. Looking Ahead: Kahn's take on the news on the horizon Greek elections raise market fears Snap Greek elections will continue to unsettle European markets on concerns of a Greek exit from the euro and a renewed European crisis. European policymakers appear overly confident that an exit no longer presents systemic risks. Time for a plan B? Ukraine’s financing gap remains unfilled, amid standoff between the International Monetary Fund and Western governments. Venezuela can't survive low oil With oil prices at current levels, Venezuela appears headed for crisis.

Bottom Line: Many experts hope that December snap elections will reenergize Japan’s structural-reform agenda, but the barriers to implementation remain high. Without progress on this “third arrow” of Abenomics, growth will remain almost fully dependent on easy money, intensifying global currency tensions in 2015. Most analysts are optimistic that this month’s elections in Japan could represent a turning point for the faltering Japanese economy. They argue a strong showing by Prime Minister Shinzo Abe’s Liberal Democratic Party (LDP) will provide a clear mandate to reinvigorate Abe’s structural-reform agenda. Indeed, the polls recently have moved in the LDP’s favor, and now suggest that the government could win well over three hundred seats in the lower house of parliament, nearly a two-thirds majority (the party currently holds 294 seats). Should Abe make economic reform a priority, he appears to have a mandate to make significant progress. Recall that structural reform was the ambitious third arrow of Abenomics, complementing monetary policy (the first arrow) and fiscal consolidation/reform (the second arrow). The government was committed to agricultural reform as part of a Trans-Pacific Partnership (TPP) agreement, as well as comprehensive labor and product market reforms. Many other governments, as well as market participants, linked their support for Abenomics to this third arrow in hopes of a supply-side effect that would allow a sustained increase in growth. To date, though, little has been accomplished. Given the continuing vested interests and political impediments to reform, my concern is that, though the government will “wave the flag” of structural reform in the coming months, the focus will quickly turn to domestic constitutional reform of the electoral system and regional defense concerns, sapping the energy behind economic reform. The fiscal arrow, in contrast, aimed to restore fiscal sustainability through upfront stimulus coupled with a multistage increase in the consumption tax. However, following weak growth numbers, the consumption tax has been delayed (though the government has committed to an increase in 2017). Although that makes a lot of sense on cyclical grounds, the government will still need to worry about fiscal credibility with government debt already in excess of 250 percent of gross domestic product (GDP). In that case, what is left to drive economic growth? Abenomics, which generated strong support based on its comprehensive three-arrow approach, would be reduced to a single arrow—aggressive monetary easing. A Sea Change for Monetary Policy Japan’s monetary policy is indeed extraordinary. At the end of October, by a five-to-four vote, the Bank of Japan (BOJ) surprised nearly everyone with a dramatic expansion of its unconventional monetary policy, citing renewed risks of deflation. If the program is fully implemented, bond holdings will be over 40 percent of GDP, adjusting for duration of the debt purchased, which is more than twice the size of the Federal Reserve’s three quantitative easing programs between 2008 and 2013. For a small, open economy such as Japan’s, easier money works in large part through the exchange rate. I would not argue that the central bank is aiming for exchange-rate depreciation, but at play is a central bank that—while motivated by domestic considerations—is taking advantage of the Fed’s turn toward normalization to make a dramatic move that ensures a substantial market impact by emphasizing the divergence of policy. As shown in Figure 1, the yen’s recent moves closely track movements in the Bank of Japan’s balance sheet. Japan has experienced sharp fluctuations in the past and there is reason to believe this time will be no different. Although some market commentators would argue that investors are already stretched, holding substantial investments that would do well in the case of a yen depreciation, from a fundamental perspective there is still some way for the yen to fall if the BOJ meets its asset-purchase targets. Still, Japan faces an uphill battle to reach its inflation target. A sharp and continuing decline in retail gasoline prices in yen, as well as the deflationary effect as the earlier consumption-tax hike wears off, has by some measures reduced underlying inflation to below 1 percent. Figure 1: The Dollar–Yen Exchange Rate and the Bank of Japan’s Balance Sheet Source: Bank of Japan; Oanda Exchange Rate Intervention In a coordinated announcement, the Japanese Government Pension Investment Fund (GPIF) announced a shift away from government bonds and toward equities, both domestic and foreign, doubling the share of equities to 50 percent. As a general rule it is not such a good idea to use government wealth funds as an instrument of monetary policy in this way: insurance and savings for future generations should be insulated from the short-term decisions that drive monetary policy. However, given that government policy has skewed previously toward support of the bond market, it can be argued that this is a good move from a longer-run perspective, and it does arguably strengthen the near-term wealth effects of quantitative easing. But it is worth highlighting that from an economic perspective, combining monetary easing with foreign asset purchases is the same as directly intervening in exchange markets, something the Group of Twenty (G20) has clearly opposed. In the context of weak global demand, it is unclear how Japan’s trading partners will respond to a sharp and continuing depreciation of the yen. To date, a number of Japan’s Asian trading partners have expressed concern, but we have not seen significant moves or the advent of a “currency war.” Credit is due to the Chinese government, which has held fire so far. But, amid softening domestic demand (the Chinese government this week lowered its growth target to 7 percent, despite substantial stimulus), any move by China to moderate the pace of renminbi appreciation against the dollar or other currencies as a response to the yen’s move would likely trigger a chain reaction in the region. Europe also will be watching the yen’s move closely. Although there are good reasons close to home for the European Central Bank to ease monetary policy, on the margin the Japanese move contributes to deflationary pressures in Europe. The United States is in a different position. Trade is a relatively small share of its economy, and so even a material appreciation is unlikely to undermine the strong growth outlook and continued strengthening of the labor market. So why worry? Indeed, U.S. policymakers appear broadly supportive of Japanese monetary policy, and see stronger growth in Japan, however achieved, as a positive contribution to the global outlook. The problem is as much political as economic. A sharp appreciation of the U.S. dollar against its major trading partners, driven by expectations that the Federal Reserve will begin to normalize policy while others ease, is bound to be contentious. There could be particular ramifications for trade. Congress is likely to produce a bill granting the president trade promotion authority (TPA), which is essential for any meaningful agreements on TPP or other trade negotiations underway. This case for bipartisanship on this issue is based on the historical Republican support for free trade, and recognition that Democrats have been the primary hurdle to passage of free trade agreements to date. Perhaps optimism is justified, but do not underestimate the risk that negotiations could go off track. In the past, both parties have pressed for tough language requiring any trade deal to address exchange-rate misalignments, and that pressure is likely to mount if dollar strength is seen as a risk for the economy. Such exchange-rate language could be a dealbreaker, as it is hard to see Japan or other U.S. trading partners making the tough concessions needed to agree to these conditions. There is much to commend the Bank of Japan for as it reverses decades of orthodox policy in order to jump-start growth with aggressive monetary easing. But relying on only one arrow presents both economic and political risks at home and abroad. Let us hope that optimism about the structural arrow proves correct. Looking Ahead: Kahn's take on the news on the horizon Draghi needs to start acting European Central Bank (ECB) President Mario Draghi has been promising to do whatever it takes to restore growth and achieve price stability, and needs to deliver now, beginning with the ECB’s December meeting. Greek elections loom Snap elections highlight Greece’s continuing economic challenges and could reinvigorate a debate over the adequacy of Europe’s crisis response. Cheap oil burns holes in government budgets Falling oil prices are putting significant pressure on a number of exporters’ government finances, including Russia, Venezuela, and Nigeria.

Bottom Line: The European Central Bank's (ECB) recent asset-quality review (AQR) and stress test of eurozone banks was an important step. But restarting growth requires stronger macro policies if Europe is to avoid a Japan-style lost decade. That includes a more concerted effort to deal with the sovereign debt overhang that is a threat to consumption, investment, and growth. In my recent Policy Innovation Memorandum (PIM), I argue that the overhang of debt is a critical constraint on growth, and call for debt relief for Europe's periphery. Why now? Partly, I expect debt issues will return to the fore over the coming years as growth stalls, adjustment fatigue increases, and spreads on periphery sovereign debt rise again. In addition, many of the critical policy debates in Europe were sidelined while awaiting the ECB-led AQR and stress test of the major European banks, which was released at the end of October. Supporters hoped that a credible stress test, and the positive market reaction that resulted, would represent a turning point in the crisis and "jump-start" the European economy. "I definitely think the banking crisis is behind us," said Dutch Finance Minister and Eurogroup President Jeroen Dijsselbloem after the release of the report. Such optimism is misguided and dangerous. The AQR and stress test constitute a serious effort to address the capital shortfall and restore confidence in the financial system, but they do not address all concerns. The review sets the stage for the ECB to emerge as the single supervisor and regulator for Europe's major banks, an important—if incomplete—step toward banking union. This effort, however, will not jump-start lending or get Europe growing again. Without growth, how confident can we really be that the crisis is over? Absent more supportive policies, the banking sector cannot regain its health, capital will remain inadequate, and a year from now the stress test may well look unconvincing. In that regard, I agree with Gavyn Davies: the exercise is a "necessary, but far from sufficient, step to fix the low-growth, low-inflation condition that has become the norm in the European economy." Europe's Three Arrows: The Japanification of Europe Concerns about European growth are a growing weight on markets. At the recent International Monetary Fund (IMF) and World Bank annual meetings, there was widespread talk of the risk of "Japanification" of the European economy, meaning a prolonged period of underperforming growth and low inflation. Though there was no consensus, I came away convinced that Europe needs its own version of Japan's Abenomics—its own "three arrows": Monetary policy. ECB sources have been quoted as suggesting that bolder action, including the purchase of government bonds (quantitative easing, or QE), could come before the end of 2014 or at the January 2015 meeting. A narrow majority (Germany is not alone in its opposition) now seems to recognize that current policies are inadequate, but it appears unlikely that the ECB will be proactive or clearly articulate its commitment to QE unless growth and inflation numbers get significantly worse. Forward guidance on policy, as much as the purchases themselves, will provide the real boost in the European case. Fiscal policy. Europe needs a more countercyclical fiscal policy, with greater spending by the surplus countries providing the demand that is missing as the periphery countries continue to consolidate, but it is hard to imagine such coordination on fiscal policy any time soon. The IMF expects European fiscal policy to be broadly neutral in 2015–2016. Structural policies. Although Spain is credited with some significant reforms, the regional reform agenda—including labor-market, spending, and product-market reforms—lags elsewhere in Europe. A comprehensive supply-side reform is needed to raise potential growth, though it should be acknowledged that structural reform often is disruptive politically and economically in the short run. There are two problems here. First, these remedies are well understood by European leaders—the problem is not imagination, but leadership. Europe remains stuck, and it seems that only a crisis can spur the needed response. Second, the downside of the analogy to Japan and the three arrows of Abenomics is that Europe should also address a fourth arrow—the debt overhang—which exerts a continuing drag on investment and confidence. With the stress test complete, now is the time to address this problem as part of a comprehensive pro-growth package. Debt Policy: The Missing Fourth Arrow Across Europe, sovereign debt is higher than it was immediately following the financial crisis. Last year, gross government debt was 175 percent of gross domestic product (GDP) in Greece and 133 percent in Italy; Portugal and Ireland's governments both hold debt stocks over 120 percent of GDP. Meanwhile, household and corporate debt remains high and continues to threaten bank balance sheets. Low interest rates make these debt burdens manageable for now, and have allowed countries such as Greece and Portugal to reenter markets. But with growth through 2015 projected at an anemic 1 percent, this is a problem deferred, not solved. Continued uncertainty over debt will condemn Europe to years of low growth and its attendant ills. Growth projections for the short- and medium-term are far too low to relieve problems like extreme unemployment—in excess of 35 percent for youths in Spain, Greece, Portugal, and Italy—and the social and political instability it can ignite. Continued weak economic performance will only further reduce confidence and investment, possibly widening the premium on periphery sovereign debt. The way out of the growth doldrums resides in forcefully tackling the debt problem. Europe's leaders need to find the political will to launch a structured debt-relief program. In my PIM, I argue that one place to begin is by looking to the Paris Club, an informal group of official creditors that convenes to address debt problems in low- and middle-income countries. Though my European friends hate my analogy to a forum that supports developing countries, clear lessons can be drawn. Specifically, Europe should implement four of the Paris Club's principles. First, rules should be adopted on a case-by-case basis to tailor restructuring programs to a country's income and debt level. Second, predictable debt relief should be conditional on policy performance, including structural reforms, continued progress toward fiscal balance, and programs to address the burden of corporate-sector debt. Third, countries should receive a cutoff date that would delimit the debt eligible for restructuring. In all cases, only debt accrued before that date would be eligible. This makes the country receiving relief fully responsible for any future debt accumulated. Finally, comparability of treatment for other creditors should not be ruled out as needed. The Paris Club framework is particularly important in the case of Europe, where much of the debt is owed to creditors in the official sector. This is particularly true in the case of Greece. At the end of last year, Greece had received a total of nearly 215 billion euros from "the Troika"—a group made up of the European Commission, the ECB (through the European Financial Stability Facility, or EFSF), and the IMF. This amount was equivalent to 108 percent of Greece's 2013 GDP and 62 percent of its total debt stock (see Figure 1). As a result of the 2012 private restructuring, the vast majority of Greece's debt is now owed to official creditors. Resolving disputes among these official creditors will be much easier if a set of rules is in place. In addition, consideration could be given to reducing debt held by the European Central Bank as part of rescue efforts. Citigroup Chief Economist Willem Buiter has an innovative proposal to cancel ECB debt holdings purchased to fund a temporary fiscal stimulus package. The principle also applies to the bonds the ECB has acquired as part of rescue efforts in the periphery. Figure 1: Greece's Troika and Non-Troika Debt, Year-End 2013 Source: European Commission Criticisms of proposals like these often start with a call for realism. It is highly unlikely that Germany and the other creditor countries would agree to commit to debt relief, even if highly conditional on policy reform, because such a commitment would make explicit the costs of sustaining the European Monetary Union with an incomplete set of economic policies. These creditors are concerned by the precedent a major debt-relief effort might set and by the issue of moral hazard (i.e., that easy relief would encourage recipient countries to relax their reform efforts and return to their bad old ways). But making explicit the cost of saving the eurozone with all its current members is simply good governance, as compared to hiding the costs by presuming they will be repaid in full. Further, the moral hazard problem, though a real concern, can be addressed by making relief conditional on performance. Finally, over the longer term, Germany does not benefit from killing its export markets in the periphery. These factors together make a compelling case for a structured program of debt relief. A Lost Decade Now is the time to embark on a comprehensive effort to restart growth in Europe, including a fourth arrow aimed at debt reduction. Low interest rates, the relief provided by earlier maturity extensions, and the confidence that could be achieved from the stress test combine to create a window for action on the debt. A year from now, if growth has not returned, indebted governments will be called on to rescue or shore up weak banks, uncertainty will return, and confidence and investment will be much harder to achieve. Europe needs a rules-based approach to debt relief. The Paris Club is one place to look for guidance to begin setting these rules. The sooner they are established, the sooner Europe will see a return to growth. Otherwise, a lost decade looms. Looking Ahead: Kahn's take on the news on the horizon Lame Outlook for the Lame Duck The U.S. Congress faces a long to-do list for the lame-duck session but is likely to achieve little; the international agenda—e.g., IMF reform and trade promotion authority— is likely to be deferred. More Economic Woes for Ukraine and Russia In Ukraine, the IMF team heads out. A large financing gap looms, calling the IMF program into question. Meanwhile, the Russian economy slips into recession. A Global Slowdown October saw analysts marking down their global growth forecasts, a trend likely to continue in November.