The beginning of the end
David Skilling & Michael O’Sullivan
Nikkei Asian Review, 15 August 2017
At the 10th anniversary of the start of the global financial crisis, the remedies put in place to staunch its financial and economic effects remain. However, in a sign that the global economy has stabilized, central bankers are signaling the end of their super-accommodative monetary policies.
The “great normalization” began with the U.S. Federal Reserve raising rates three times amid deafening silence from low-volatility markets. Other authorities have followed, notably the European Central Bank, with markets egging on the end of quantitative easing, and the Bank of England, where a debate on inflation is underway. Both the euro and the pound have risen against the dollar, but in both cases diminished political risk has played a role.
Yet the best illustration of the consequences of this new policy trend will likely come from small, open economies, particularly those outside the eurozone which have been deeply impacted by QE.
In countries from New Zealand and Singapore to Switzerland and Sweden, interest rates have been held down to remarkably low levels — negative in several cases — and exchange rates have soared. Small, developed country currencies have been 5% stronger than their large, advanced economy counterparts over the past seven months. Meanwhile, prices of assets such as property and equities have appreciated strongly. Being a small country central banker has been a particularly tough job. Hong Kong has also been directly affected by QE, importing loose monetary policy via its currency peg to the U.S. dollar.
These pressures are still present. For small economies outside the eurozone, the average inflation rate in June was just 1.1% despite policy rates at historically low levels. Several of these economies, notably New Zealand, Israel and Sweden, have been traveling well in terms of gross domestic product growth, but broad inflationary pressures have been absent.
There are some country-specific reasons for this, such as the impact of migration on wages in New Zealand, but high exchange rates have contributed to low levels of inflation. The policy dilemma is that the price pressures encouraged by low interest rates have shown up in asset prices rather than in consumer prices.
Countries like Sweden and Switzerland provide good examples of these pressures. The Riksbank in high-growth Sweden has been forced to extraordinary lengths to hit its inflation target, with negative rates and a program of QE, resulting in high property prices and a weak currency. Similarly, Switzerland has negative policy rates, an elevated exchange rate that despite a recent sell-off is still hurting its export sector, and a very large central bank balance sheet.
So an orderly process of normalization by the large central banks would be welcome. But as ever, the challenge for small countries will be to manage the side effects of this process. Global monetary policy has not been well-tuned to the small country context over the last several years — and the next period may not be any easier to manage.
What to watch for?
If all goes well, the next phase in the normalization process is that yield curves will steepen, as longer-term bonds sell off and short-term rates gradually rise. This may help banks and might also herald a pick-up in investment spending. However, new problems will emerge.
Property and housing is one significant issue. With the exception of Singapore, which has seen gently declining real estate prices since implementing aggressive property market cooling measures in 2013, most small open economies have experienced sharp run-ups in housing prices. Hong Kong and New Zealand are two clear cases of this in the Asia-Pacific region. An abrupt rise in rates would cause problems in these housing markets and in other small economies, with the potential for a negative impact on the real economy as well.
The challenge is that the rising rates profile comes at a time when growth rates are beginning to slow in New Zealand, Singapore and several other small economies. The strong recovery in Europe will help countries such as Sweden and Switzerland, but a rising rates profile may not sit well with their domestic business cycles. Small economies will need to balance slowing growth, weakening asset prices and rising inflation — at a time when rates are increasing in the core.
This may be a bumpy process. Small, open economies may provide an example of the transfer of policy responsibility from central bankers to elected officials. Another key concern that small countries will face is wage bargaining. Labor market institutions in small European countries from the Nordics to Ireland mean that wages may be more responsive to rising living costs.
So while politics in small states may not be as exciting as in Washington, political debates in small, developed countries may offer a better guide to global inflationary pressures than U.S. non-farm payroll figures.
The world is finally entering a new phase, which will have material economic, financial and political implications.
Policymakers, analysts, investors and business people will need a new dashboard to navigate this. Movements in the U.S. Treasury market and the euro may not provide a clear steer. Instead, keep an eye out for signals from the Hang Seng index, New Zealand bond yields, Viennese property prices, the Swedish kroner and Irish wages.
Michael O’Sullivan is chief investment officer in the international wealth management division of Credit Suisse and author of “Ireland and the Global Question.” David Skilling is director of Landfall Strategy Group, an economic research and advisory company in Singapore.