Bank of England governor Mark Carney delivered a landmark speech at the G20 meeting in Shanghai last week.
Titled “Redeeming an unforgiving world” Carney gave his take on global growth now and the big step down since the GFC, the recent market turbulence, financial reform, and the state of the financial system – he said “there will be no Basel IV.”
But it was his discussion around monetary policy and the impact on the real economy as opposed to financial markets which was the most important message he delivered.
Carney neatly highlighted how central banks, “by deploying a broad range of ammunition”, stimulated the economy through a number of channels (his emphasis):
Lower policy rates brought forward consumption to today from spending tomorrow – the real interest rate channel.
The all-in costs of borrowing were lowered, boosting existing borrowers’ spending power – the cash flow channel. And lower funding costs for banks increased the availability of credit – the credit channel.
Lower discount rates and portfolio balance effects supported asset prices – the wealth channel.
Currencies’ values fell, boosting competitiveness – the exchange rate channel.
And determined central bank action and forward guidance put a floor under inflation expectations and bolstered sentiment – the confidence channel.
That, Carney said, is how “central bank actions combatted the worst global downturn since the Great Depression.”
But he also highlighted that monetary policy has it limitations.
“Low interest real rates have bought time by bringing forward demand to today from tomorrow. But, to paraphrase my predecessor, Lord King, having brought forward demand for years, tomorrow is now yesterday (and he said that three years ago!). In other words, most central banks need the other channels of monetary policy to work harder.”
That’s why unconventional policies such as asset purchases such as quantitive easing have been undertaken in such large size by many central banks. These policies were aimed at the wealth channel he said.
But Carney added an important caveat. One that supports notions, like those of US money manager John Hussman, that stocks are currently in the throes of a readjustment in prices to reflected the reality of where the global economy is sitting and the prospects for earnings and growth as a result of that outlook for the real economy.
In his semi-annual report to investors – published on February 27 – Hussman wrote:
From the standpoint of our investment discipline, the present environment couples the second most extreme market valuations in history (exceeded only by the 2000 bubble peak) with a clear deterioration in our measures of market internals…
In late-2015, we observed the combination of falling stock prices, widening credit spreads, a relatively modest spread between long-term and short-term interest rates, and a decline in the ISM Purchasing Managers Index below 50. While none of these measures is significantly correlated with economic recessions individually, the full combination – a syndrome that comprises our basic Recession Warning Composite – has generally been a useful early warning signal of oncoming economic difficulties, as I observed in real-time in 2000 and 2007.
Carney explained the wealth effect, overvaluation, why Hussman is right and stocks are struggling at current prices, noting that QE’s wealth effect ultimately proves temporary.
“The effect of QE on the wealth channel cannot last forever. Monetary neutrality means real asset prices are not boosted indefinitely by such policies; their economic effects must ultimately unwind,” he said.
To reiterate the point he added (our emphasis):
Said differently, unless an improvement in fundamentals boosts the underlying cash flows of these assets, real valuations will fall back. That structural policies have not boosted real growth sufficiently is a better justification for the re-pricing in risk markets than any loss of confidence in the power of central banks.
In layman’s terms, the global economy hasn’t picked up as expected and just doesn’t support the level to which traders and investors had driven a number of asset markets around the globe.
It’s not hard to see why this recognition, and the end of the half-life of QE’s impact on markets, have ushered in such a difficult year for markets in 2016.
As a result, Carney says it’s time for the G20 to get busy. Busy with continued innovative policy tools such as negative interest rates, and busy with plans agreed at the Brisbane summit in 2014 to increase global growth.
Carney says “less than half of the measures have been implemented, and only around one third of the promised impact on global GDP has been delivered. Moreover, whilst implementation has lagged, the need to boost growth has increased in size and urgency.”
Crucially and perhaps in the one statement that ties his whole argument together with Hussman, others, and 2016’s market ructions Carney said:
The Bank of England projects the level of global GDP in 2018 to be
over 3% below what the IMF expected at the time of the Brisbane summit.
That’s one heck of an undershoot. No wonder markets are in a funk.