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Central Banks Search Toolbox for Ideas as Growth Slows

July 26, 2012

Central Banks Search Toolbox for Ideas as Growth Slows

The European Central Bank (ECB) headquarters in Frankfurt. Photographer: Hannelore Foerster/Bloomberg

Central banks are digging deeper into their tool kits in search of innovative ways to unclog bank lending and keep a weakening world economy afloat.

With the fifth anniversary of the financial crisis approaching in August, policy makers from the Federal Reserve, the European Central Bank and the Bank of England all meet within 24 hours next week. Central banks, facing a global recovery that’s sputtering even after they delivered trillions of dollars of liquidity and near-zero interest rates, are having to consider fresh strategies to combat the slowdown.

“Central banks are thinking hard about other ways to spur their economies and get credit into corners of the economies that need it and aren’t getting it,” said Nathan Sheets, global head of international economics at Citigroup Inc. in New York and director of the Fed’s international finance division until last year.

Among the options up for consideration by the monetary authorities in addition to potentially doubling-down on previous policies: taking some of the credit risk of new lending onto their own balance sheets and forcing commercial banks to pay for parking cash in central banks’ coffers.

The likelihood of even easier policies leaves John Stopford, head of fixed income at Investec Asset Management in London, advising investors to buy the bonds of traditionally safe economies such as the U.S. U.S. Treasury 10-year notes yesterday traded at a record low yield of 1.3790 percent. He suggests steering clear of cash.

Keep Trying

“It’s not obvious central banks have been effective, but they’re going to keep trying,” said Stopford, whose company oversees about $98 billion.

Fed Chairman Ben S. Bernanke’s Federal Open Market Committee meets July 31 and Aug. 1, a day before ECB President Mario Draghi’s Governing Council and BOE Governor Mervyn King’s Monetary Policy Committee. The institutions’ last meetings ended with the Fed extending its Operation Twist program, the ECB cutting its benchmark rate to a record low 0.75 percent and the Bank of England restarting bond buying.

Faced with a European debt crisis that’s engulfing Spain and a stagnating U.S. labor market with unemployment at 8.2 percent, they may need to do more soon. The International Monetary Fund this month cut its 2013 growth outlook for the advanced economies to 1.9 percent from 2.1 percent. It left its 2012 estimate at 1.4 percent.

‘Exceptionally Low’

“The global macroeconomic environment is softening,” Carlo Bozotti, chief executive officer at STMicroelectronics NV (STM), Europe’s largest chipmaker, said July 24 as he indicated third- quarter sales may miss analysts’ estimates amid weaker demand.

The central banks can still deploy tools they’ve adopted before. The Fed may decide to extend its assurance that interest rates will be kept “exceptionally low” into the middle of 2015, from late 2014 now, according to Roberto Perli, managing director in charge of policy research at International Strategy & Investment Group Inc. in Washington.

Neal Soss, chief economist at Credit Suisse Group AG in New York, sees about a one-in-three chance that the Fed will begin another round of bond buying next week. The odds of the Fed agreeing at its September meeting to launch a third round of quantitative easing, known as QE3, are almost two in three, he added.

Draghi Openness

At the ECB, Draghi is reiterating openness to do more. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,” Draghi said in a London speech today. “And believe me, it will be enough.”

That comment triggered speculation among investors that the ECB will soon buy the bonds of strained markets four months after it stopped doing so because it wanted governments to do more to cut budget deficits, said Ken Wattret, chief market economist for the euro region at BNP Paribas SA.

The ECB will reduce its key rate to 0.5 percent in September to protect price stability and make it cheaper for cash-strapped banks to borrow from it, Wattret said. The central bank for the 17 euro countries also will lower the rate it pays on overnight deposits to minus 0.25 percent from zero, to encourage banks to use the money for more productive purposes, the London-based economist said.

The trouble is that low interest rates, floods of cash and bond-buying have failed to ignite full-fledged recoveries after the financial crisis left banks reluctant to lend. Banks in countries using the euro are further hamstrung by the ever-less- valuable bonds they own of cash-strapped peripheral nations.

“The lending channel is broken,” said Perli, a former Fed economist.

Mortgage Securities

Bernanke himself told Congress this month that the Fed is considering a range of further options to ease policy in case the faltering economic recovery fails to lower unemployment.

“We haven’t really come to a specific choice at this point, but we are looking for ways to address the weakness in the economy should more action be needed to promote a sustained recovery in the labor market,” he told the Senate Banking Committee on July 17.

One of those ways could be buying up home mortgage securities rather than Treasuries to encourage lending, Credit Suisse’s Soss said. In its first round of QE, the central bank bought Treasuries and housing debt, while it limited its purchases to Treasuries in the second round.

The impact of buying only mortgage bonds would be muted, with the average rate for a 30-year mortgage having already hit a record low of 3.53 percent for the week ended July 19, according to Soss, who was an assistant to former Fed Chairman Paul Volcker.

Lending Program

Bernanke also has voiced interest in the Bank of England’s funding for lending program and has suggested the Fed is exploring whether it can use its discount window in that regard. The BOE plan rewards new lending with access to cheaper financing.

Under a proposal put forward by St. Louis-based Macroeconomic Advisers, the Fed would create a program to extend longer-term credit to banks using home mortgages as collateral. The aim would be to embolden the banks into granting loans to borrowers who currently don’t have access to such credit.

“Not all of the economy is feeling the beneficial effect of low interest rates,” said Antulio Bomfin, a former Fed official who is now a senior managing director at Macroeconomic Advisers. ‘You see that the most in the mortgage market.”

‘Highly Critical’

Such a strategy probably would be met by opposition from congressional Republicans, who are already concerned that the Fed is risking future inflation with its easy money policies.

“My sense is that Republicans will be highly critical of the Fed if it pursues additional stimulus in any form,” said Sarah Binder, a senior fellow at the Brookings Institution in Washington. “Venturing into mortgage markets beyond buying mortgage-backed securities seems to be a step too far into fiscal policy for Fed critics.”

Bernanke also has left open the possibility that the central bank will cut the 0.25 percent interest rate it pays commercial banks on reserves. Such a move, which has repeatedly been advocated by former Fed vice chairman Alan Blinder, was shelved by the Fed last September partly out of concern it would disrupt money markets and interfere with the extension of credit.

Spanish Bonds

The ECB also may need to do more as the impact of its July 5 rate cuts fade with the reigniting of the debt crisis and the region’s economy stagnating. Spanish 10-year bond yields this week rose above 7.5 percent for the first time since the 1999 creation of the euro and German business confidence fell more in July than economists forecast, to the lowest in two years.

Lower interest rates may induce banks to stop lending to each other because the returns are no longer large enough to cover transaction costs, said Jennifer McKeown, an economist at Capital Economics Ltd. Money market funds, a source of bank financing, are restricting new investment because the securities they invest in pay negative returns, she said.

“The ECB will need to try more imaginative policies to stand a chance of breathing life into the euro zone’s banking sector and wider economy,” said McKeown in London.

One option is to offer banks a third chance to borrow as much cheap cash as they want for three years, said Goldman Sachs Group Inc. economist Dirk Schumacher. Although the ECB already lent 1.02 trillion euros ($1.24 trillion) that way to help banks, the point of another round would be to prompt investors to buy riskier debt of countries such as Spain.

Emergency Loans

Other options include mimicking the Fed by giving greater guidance over the future direction of interest rates and lowering bank reserve requirements, said Schumacher in Frankfurt.

The ECB could also broaden the collateral it accepts when making emergency loans, perhaps by suspending the complete use of sovereign ratings in deciding what is eligible, or reducing the haircuts it imposes, he said. As well as generating cash for banks, that could also prompt the firms to create economy- boosting assets they can then borrow against, such as household and corporate loans.

In a sign it is willing to act even if it undermines its balance sheet, the ECB last month lowered the minimum rating threshold for mortgage-backed securities to BBB- from A-, offering support for Spanish banks in particular which had been unable to use some securities for loans.

Double-Dip Recession

At the Bank of England, officials say they may eventually reassess cutting their 0.5 percent benchmark and JPMorgan Chase & Co. predicts they will boost their so-called quantitative easing program from the current 375 billion pounds ($580 billion). In the meantime, U.K. central bankers are getting more creative.

In an effort to find a new way get the banks to do more and temper the first double-dip recession since the 1970s, they unveiled this month a funding for lending program along with the U.K. Treasury. Under the plan, banks will be able to borrow treasury bills from the central bank for a fee and collateral from Aug. 1 to fund lending into the economy.

Banks will have 18 months to use the facility and then as many as four years to repay. The Bank of England would thus be exposed to potential balance sheet losses should the collateral go bad and the bank have trouble repaying. Any Fed program would face the same drawback.

There is pressure for stronger steps. Charles Wyplosz, director of the International Center for Money and Banking Studies in Geneva, says the crisis will only end once the ECB either partly guarantees all euro-area debt or caps bond yields.

Quantitative Easing

The ECB will ultimately be forced to consider policies it previously resisted, namely quantitative easing to avert deflation and supersizing Europe’s rescue fund by giving it access to central bank cash, said David Owen, chief European financial economist at Jefferies International Ltd. in London.

He estimates asset purchases totaling 500 billion euros and spreading across the region will begin by the end of the year. ECB Governing Council member Ewald Nowotny said in a July 24 interview that there are “pro arguments” for allowing the European Stability Mechanism rescue fund to access ECB lending, although Draghi said May 24 that giving it a bank license would amount to the central bank financing governments, which is prohibited.

Meantime, the Bank of Japan may also be willing to adopt fresh forms of monetary easing should it prove difficult to raise inflation to the target of 1 percent, two new board members suggested. Buying foreign bonds would be one option, Takehiro Sato said on July 24.

For all the internal debates and added risk they may take on, monetary policy makers may be fighting a losing battle given they’re working against a debt-laden world economy, said Peter Fisher, New York-based head of fixed income at BlackRock Inc.

“Central banks have put in very accommodative policies and in general where deleveraging is taking place you’ve got to get used to lags and longer than usual ones,” Fisher, a former Fed official, said on July 16. “I’m nervous at the rationale that by expanding balance sheets they can respond to a modest downward trend.”

To contact the reporters on this story: Simon Kennedy in London at skennedy4@bloomberg.net; Rich Miller in Washington at rmiller28@bloomberg.net

To contact the editors responsible for this story: Craig Stirling at cstirling1@bloomberg.net; Chris Wellisz at cwellisz@bloomberg.net


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