World overview: focus on national monetary policies.

Holland, Dawn ; Delannoy, Aurelie ; Fic, Tatiana 等

In the October 2011 Review, we considered the probability of each of the major economies suffering a recession by the end of 2012. This probability hinged crucially on our assumptions regarding the evolution of the sovereign debt crisis facing the Euro Area. Under our scenario where policymakers continued to 'muddle through' the crisis throughout most of 2012 we envisaged a 70 per cent chance of recession in the UK, more than a 50 per cent risk of recession in the Euro Area, with much higher risks in Italy and Spain, and about a 25 per cent chance of recession in the US and Canada. The Japanese economy suffered a recession in 2011, but on balance was expected to expand in 2012 under this outturn for the world economy. We also considered a 'best-case' scenario, in which decisive action by European policymakers led to a rapid resolution to the crisis by the end of last year. Even in October, the likelihood of achieving this best-case outcome was becoming distant, and under this scenario we still attached close to a 50 per cent chance of recession in the UK and a 30 per cent probability of recession in the Euro Area as a whole. In China, India and many other emerging economies we generally attach a low probability to observing a technical recession, defined as two consecutive quarters of output decline. But growth significantly below trend in these economies would have a similar effect on employment and incomes to what we define as recession in the more advanced economies, and the risks of such a slowdown increases the longer the Euro Area crisis is prolonged.

We have seen little improvement in prospects for the Euro Area crisis over the past three months, as European policymakers indeed continue to muddle their way through. Our current baseline forecast is largely in line with our October expectations based on such a delayed resolution. We are expecting a recession in the first half of 2012 in the Euro Area and the UK, and forecast growth of 1.9 per cent in the US and Canada, 1.8 per cent in Japan, 8.5 per cent in China and 7.2 per cent in India for the year as a whole. A summary of our main global forecast figures is reported in table 1. The methodological approach to the forecast and key underlying assumptions are discussed in Appendix A, while detailed projections for 40 countries are reported in Appendix B at the end of this chapter.

The political leadership in several European countries changed over the course of 2011 (Italy, Greece, Portugal, Ireland, Spain) and a succession of policy proposals have been put forward by European leaders, with the most recent developments including an agreement among Euro Area leaders to move towards a stronger economic union and fiscal compact and new measures to support bank lending and money market activity, both put forward in early December. New leadership has led to more decisive fiscal consolidation and in some cases structural reform in the countries concerned. But measures implemented so far have not been sufficient to restore market confidence in the ability of a number of Euro Area governments to meet forthcoming debt obligations, not least because fiscal tightening is impacting on growth. Since the end of October, government bond yields have continued to rise in Greece, Portugal and Italy, while spreads relative to Germany have also risen in Austria, France, Spain and Belgium, as illustrated in figure 1. We have also seen sovereign downgrades by the rating agency Standard and Poor's in nine Euro Area economies since the start of the year (Italy, Spain, Portugal, Cyprus, France, Austria, Malta, Slovakia and Slovenia), as well as a downgrade of bonds issued by the European Financial Stability Facility (EFSF), the lending facility set up to finance the bail-out programmes in Greece, Ireland and Portugal. Developments in sovereign ratings since 2007 are reported in table 2.

At the same time, lending conditions have tightened sharply across Europe--partly in response to the adverse results of stress tests by the European Banking Authority released in December. According to the October 2011 Bank Lending Survey of the European Central Bank, the net tightening of credit standards by Euro Area banks picked up significantly in the third quarter of 2011 and was expected to rise further by the end of the year. This corresponds also to the sharp rise in corporate bond spreads over government bond spreads, as shown in figure 2. In addition, fiscal austerity measures continue to act as a strong restraint on growth in Europe (see the Box above), and to a lesser extent in the US. Monetary policy remains loose, and we have seen further measures of easing in the US, UK and Euro Area since October. These measures are discussed within the relevant country sections in this Review.

Box A: Impact of fiscal austerity in the Euro Area

by Dawn Holland * and Gerhard Runstler **

Many of the major economies introduced fiscal tightening measures
last year despite the widespread slowdown in GDP growth. The IMF
estimates that the overall global fiscal balance improved by I per
cent of GDP in 2011 (IMF Fiscal Monitor Update, 2012). Fiscal
stimulus packages and support to the financial sector in the wake
of the financial crisis of 2008-9, coupled with the collapse of
housing market bubbles in a number of countries, have been
associated with a sharp rise in government debt, towards levels
that are viewed by financial markets as unsustainable in some
countries. Severe austerity programmes have been put in place
across most of the Euro Area in particular in an effort to narrow
the widening risk premia on sovereign debt.

Euroframe (2012) assesses the impact of planned fiscal tightening
measures in the EU for 2011-13 on the Euro Area economy through a
series of NiGEM simulations. According to these estimates, in the
absence of fiscal tightening measures the Euro Area economy could
have expanded by 2.2-2.5 per cent last year, and would be expected
to grow by 0.6-1.1 per cent in 2012, compared to NIESR's current
forecast for a contraction of 0.2 per cent this year.

The Euroframe scenarios treat the risk premium on government debt
as exogenous, and in this box we extend that analysis to allow for
a potential endogenous response of risk premia to the improvement
in the fiscal position. As highlighted by the IMF World Economic
Outlook (September 2011), over the past two years an important
feedback has been introduced through the impact of the prospective
fiscal position in some countries on the risk premium applying to
government borrowing in those countries. To the extent that
confidence in the sustainability of public finances is restored by
the consolidation efforts, the effect on real activity and
employment would be weaker than suggested by the scenarios that
treat government risk premia as exogenous. First, a decline in bond
yields would reduce the burden on public finances and break the
vicious circle between high yields and low confidence that has
emerged in recent months. Second, this would also support banks'
balance sheets and thereby reduce the risk of tighter credit
conditions.

The size of the impact of fiscal consolidation on bond yields is
difficult to quantify, however. It certainly depends on the
credibility of the national measures and of efforts to achieve an
improved policy coordination in the Euro Area. Various empirical
studies have argued that public debt levels of 90-100 per cent of
GDP mark a critical point. Beyond this point, further rises in debt
would increasingly generate pressures on bond yields and result in
persistently lower GDP growth. Other studies find that a reduction
in fiscal deficits of I per cent of GDP would reduce yields by
about 20 basis points. (1) Given the magnitude of government risk
premia within the Euro Area at the moment, these effects are very
modest, but may prove significant. In order to quantify the
expected impact of such an adjustment in risk premia, we allow a 20
basis point decline in the government bond yield for each I per
cent of GDP improvement in the budget deficit in those countries
that currently have public debt levels in excess of 100 per cent of
GDP: Greece, Ireland, Portugal, Italy and Belgium. The adjustment
is made in each year, with adaptive rather than rational
expectations, as we have yet to see evidence of such an adjustment
in most of the Euro Area economies to date, despite the fiscal
programmes put forward. At the Euro Area level, this adjustment
would offset the negative impact of the tightening measures on GDP
growth by 0.1 percentage point in 2011, by 0.3 percentage points in
2012 and by 0.4 percentage points in 2013. This would go some way
towards offsetting the contractionary impact of the fiscal
tightening measures at the Euro Area-wide level.

It is possible that the impact of fiscal improvement could prove
more significant than suggested by the analysis above. For example,
if we allowed for a loosening of bank lending conditions to reflect
the improvement in bank balance sheets that follows from the
decline in bond yields, this would support borrowing by both firms
and consumers. Another issue to consider is that most of the
studies used to calibrate the size of the impact are based on
countries with flexible exchange rate regimes, and so we have to
think how the results translate for the case of a currency union.
There is an argument that the effect on bond yields may be larger,
as a currency union tends to amplify default risk. (2)

NOTES

(1) See for example Laubach, T. (2009), 'New evidence on the
interest rate effects of budget deficits and debt', Journal of the
European Economic Association, 7, pp. 858-85; Checherita, C. and
Rother, P. (2010), 'The impact of high and growing public
government debt on economic growth', ECB working paper 1237;
Baldacci, E. and Kumar, M. (2010), 'Fiscal deficits, public debt
and sovereign bond yields', IMF working paper 10/184.

(2) See for example de Grawe (2011), 'A fragile Eurozone in search
of a better governance', CESifo working paper 3456.

* NIESR (dholland@niesr.ac.uk). ** WIFO Austrian Institute of
Economic Research (Gerhard.Ruenstler@wifo.ac.at).

[FIGURE 1 OMITTED]

Policy options in the Euro Area are limited. The Euro Area comprises a full monetary union governed by a specific form of independent central bank, (1) while permitting fiscal independence of the individual member states. It was hoped that the Stability and Growth Pact would be sufficient to ensure fiscal sustainability within each member state, obviating the need for a central bank to guarantee government debt obligations of individual member states. The obvious flaws in such a plan were highlighted by, for example Wyplosz (1991), but the political will for monetary union was strong and policymakers decided to forge ahead with the monetary union, while keeping ideas such as 'fiscal harmonisation' on the agenda for discussion, without any serious plans for implementation. The largest members of EMU, Germany and France, breached the Stability and Growth Pact in 2003 without penalty, thus rendering it effectively moribund. Nonetheless, until 2010 financial markets continued to price sovereign risk in Greece and other Euro Area countries as roughly equivalent to that in Germany.

[FIGURE 2 OMITTED]

It is clear that a resolution to the Euro Area crisis will require a decisive commitment by European leaders to move in one of two opposing directions: either towards stronger economic and political integration and a move in the direction of fiscal union; or towards a weaker union, entailing development of an exit strategy from the euro, which Holland and Kirby (2011) demonstrate may prove costly even if short-term disruption can be contained. Our central forecast assumes that EMU remains intact, which necessarily implies a move in the direction of fiscal union, with some of the stronger states acting as guarantors of the debt obligations of the weaker states. This could be effected by a strong commitment by the ECB to buy public debt on a large scale, taking on the role of lender-of-last-resort at the government level, or by the issuance of 'Eurobonds' under the guarantee of the stronger states. Obstacles to such moves include current treaties that specifically preclude such actions (2) and strong opposition in certain countries, but the alternative, which could lead to widespread default and even a break-up of the EMU itself, would probably be far more damaging to the economies in the Euro Area, not least owing to the magnitude of cross-border banking exposures to sovereign debt.

Our forecast makes the assumption that the commitment to monetary union and the benefits this has brought the region since 1999 (see ie Buti et al., 2010) will override the commitment to fiscal independence--as evidenced by the announcement on 9 December of a move towards a new fiscal compact. We expect a decisive agreement to be reached by the second half of 2012 that will ensure European sovereigns are able to meet their borrowing needs at reasonable rates of interest. However, we do not attempt to address the difficult political economy questions behind this decision-making process, and how such an agreement is reached. We expect risk premia on government debt (3) within the Euro Area to remain at current levels until the third quarter of 2012, but begin to recede by 10 per cent per quarter in the final quarter of the year, as the policy action gains credibility. We also expect bank lending conditions in Europe to ease in the second half of 2012, as recapitalisation requirements are met and uncertainty eases (see Euroframe, 2012 for a discussion of the assumptions underlying bank lending conditions, which affect not only banks in the Euro Area, but across the EU, due to strong interbank linkages within the Union).

Policy actions in Europe are likely to include a move towards quantitative easing in the Euro Area. Bernanke and Reinhart (2004) discuss the options for monetary policy when interest rates are very low. The policy options they discuss include: shaping interest-rate expectations; altering the composition of the central bank's balance sheet; and expanding the size of the central bank's balance sheet, or quantitative easing. Since the onset of the financial crisis, when interest rates in the major economies were cut to unprecedentedly low levels, all three policy tools have been adopted by one or more of the five major central banks to a lesser or greater degree, as discussed by Barrell and Holland (2010).

The US Federal Reserve and the Bank of Canada have tried to shape interest rate expectations by announcing that interest rates will remain low for an extended period, thus flattening the yield curve and consequently putting downward pressure on longer-term bond yields. The most recent example is an announcement made by the Federal Open Market Committee following its meeting of 25 January 2012, that it expects US policy rates to remain low until at least late 2014, extending the period suggested in its previous statement by about a year. The Bank of Japan has also adopted a strategy of shaping interest rate expectations, but made this commitment conditional on deflation coming to an end, on the basis of the "understanding of medium- to long-term price stability", rather than providing a more explicit forecast for the interest rate path.

All of the major OECD central banks have introduced policies to change the composition of their balance sheets. This approach was pioneered by the so-called 'Operation Twist' introduced by the Federal Reserve in the early 1960s, which involved swapping short-term bonds for long-dated Treasuries to invert the yield curve, pushing down longer-term interest rates to encourage investment while holding short-term interest rates and the exchange rate up. Monetary easing measures of the ECB have focused on policy easing measures that change the composition of the balance sheet rather than the size of the balance sheet, buying euro-denominated covered bonds as part of what it calls "enhanced credit support". Covered bonds are bonds issued by banks and backed by the cash flows generated from an underlying investment pool. The Eurosystem has launched two Covered Bond Purchase Programmes in order to purchase euro-denominated covered bonds. Since May 2010 it has also conducted interventions in debt markets under the Securities Market Programme. The Securities Market Programme has been used to ease pressure on government bond yields in vulnerable countries, but not to increase the money supply, as the purchase of bonds is generally matched by an increase in deposits with the ECB. The most recent policy of the ECB, which offers 3-year loans to banks, is more accommodative than the previous forms of liquidity provision, as a wider range of assets are accepted as collateral, including assets with a BBB- rating. The hope is that banks will re-invest at least part of the loans in Euro Area sovereign debt, bringing some relief to bond yields. At the time of writing there is some tentative evidence of this. The recent measures introduced by the ECB are discussed in more detail in the Europe section below.

[FIGURE 3 OMITTED]

Quantitative easing differs from the primary policies adopted so far by the ECB in that the monetary interventions are unsterilised. Sterilised policy provides liquidity to specific markets, offset by a withdrawal of liquidity in others--for example providing liquidity in the short-term financing market can be sterilised by issuing longer-term debt, keeping the central bank balance sheet constant, or indeed swapping government bonds that bear a low risk premium for those that bear a higher risk premium. In contrast to the ECB, large-scale quantitative easing--in effect boosting the money supply--has been employed by the Federal Reserve, the Bank of England and the Bank of Japan since 2009. Figure 3 shows the size of central bank balance sheets as a per cent of GDP in the major economies. Relative to GDP, the ECB balance sheet is larger than either the Bank of England or the Federal Reserve. While the ECB balance sheet rose sharply in 2009 reflecting liquidity provision to the banking system, this rise was less than half that of the Bank of England and Federal Reserve, which also engaged in quantitative easing.

The Bank of England has effected quantitative easing almost entirely through purchases of government paper. Over the period March 2009 to January 2010, 200 billion [pounds sterling] of assets were purchased by the Bank of England, overwhelmingly made up of government securities, representing around 14 per cent of annual GDR A very small proportion of purchases consisted of corporate bonds and commercial paper. A further 75 billion [pounds sterling] of gilt purchases commenced in October 2011, and the second round of purchases should be completed towards the end of January 2012.

In contrast, in the United States the Federal Reserve focused largely on the purchase of mortgage-backed securities (MBS). Between 5 December 2008 and 31 March 2010 the Federal Reserve purchased $1.4 trillion of agency debt and agency MBS. (4) While there was a temporary shift towards reinvesting principal payments from the agency debt and agency MBS in longer-term Treasury securities, since 3 October 2011 this move was reversed. The value of all securities held by the Federal Reserve was $2.6 trillion on 4 January 2012. This included $838 billion worth of MBS and $104 billion of Federal Agency Securities. This compares to total assets of the Federal Reserves valued at $900 billion in August 2008.

Japan first introduced quantitative easing in March 2001, and the bond purchasing programme that extended to March 2006 was entirely geared towards the purchase of Japanese Government Bonds. Following the onset of the global financial crisis, the Bank of Japan embarked on a new round of monetary easing measures, and the Comprehensive Monetary Easing (CME) policy introduced in October 2010 included quantitative easing measures through the purchase of corporate bonds, commercial paper, and the financial assets of exchange-traded funds (ETFs) and real estate investment trusts (REITs) in addition to government securities.

The Bank of Canada (2009) defines the purchase of private sector debt by the central bank, as opposed to public sector debt, as credit easing. This can be effected either through quantitative easing, or through an adjustment to the composition of the central bank balance sheet. Credit easing targets the risk premium between 'risk-free' public sector borrowing costs and private sector borrowing costs, and Barrell and Holland (2010) suggest that if the Bank of England had followed a policy that more closely resembled that of the Federal Reserve in 2009, this might have reduced the rate of contraction in the UK by up to 1 percentage point in that year.

While private sector lending conditions have tightened significantly across Europe, of more immediate concern is the risk premium that continues to widen on public sector borrowing costs in most Euro Area countries. As such, any quantitative easing measures introduced by the ECB are likely to be in the more traditional form of investment in public sector securities. A large number of studies have looked at the impact of quantitative easing measures on interest rates and the real economy, and these can be used as a guide to what any ECB policy can achieve.

Miles (2011) and Benford et al. (2009) explain the Bank of England's view on the multiple channels through which quantitative easing affects the real economy. The key channels that they highlight are the term premium, private sector borrowing costs and the availability of bank credit. The purchase of long-term government securities is expected to reduce the premium on both risk-free and risky long-dated financial assets in circulation, pushing up the price of the asset and raising the value of financial wealth, which in turn feeds into domestic demand through consumer spending. The decline in government bond yields is also expected to be passed through to private sector borrowing costs, raising domestic demand through investment. Meanwhile, the increase in liquid assets in the banking system may ease liquidity constraints in the banking sector and reduce lending constraints, allowing a higher level of borrowing by both households and firms.

Much of the empirical literature studying the effects of quantitative easing is based on the Japanese experience of 2001-6. Ugai (2007) surveys some of the earlier studies and broader studies of monetary policy transmission at low interest rates in general. Effects arising from the Bank of Japan's commitment to low interest rates for an extended period were found to have the strongest impact on longer-term yields. There was only limited evidence of a direct impact from quantitative easing on the costs of corporate finance, as the credit transmission in Japan's banking system was severely impaired. The recent monetary easing policies introduced by the Bank of Japan have generated a renewed interest in the effectiveness of quantitative easing. Lam (2011) uses an event study approach to access the impact of recent monetary easing measures on financial markets and finds a statistically significant impact on government bond yields and equity prices, but no notable effect on exchange rate and inflation expectations. His findings are partly in line with results from Berkmen (2012) who used a structural VAR model to evaluate the effect of the Bank of Japan's monetary policy measures covering both periods of quantitative easing, 1998-2010. He found weak evidence of an effect on growth as well as inflation albeit no effect on the exchange rate.

Gagnon et al. (2011) review the experience of the Federal Reserve and find effects on both the term premium and private sector borrowing costs, and estimate that the measures introduced to March 2010 reduced long-term interest rates by 30-100 basis points. Meaning and Zhu (2011) also found that the quantitative easing policies of the Federal Reserve and the Bank of England had significantly reduced yields on longer-term bonds, with the impact per billion dollars spent in the two countries broadly comparable. Krishnamurthy and Vissing-Jorgensen (2011) find similar results, and highlight the additional effect on corporate spreads that Federal Reserve policy has had, whereas Joyce et al. (2011) find no significant effect on corporate spreads in the UK, where quantitative easing was effectively limited to investment in government debt. Meaning and Zhu (2011) warn that once the central bank holds a large share of sovereign debt there may be diminishing returns to quantitative easing. This is relevant to the ECB, as the balance sheet is already large relative to the Bank of England and the Federal Reserve, after allowing for the size of GDP.

Few studies have been able to confidently identify evidence of an effect on the availability of bank credit, despite significant effects on borrowing rates, suggesting that the transmission to the real economy may be less effective than suggested. Scepticism regarding this transmission channel is hardly a new development. In an open letter to President Roosevelt in 1933, Keynes likened policies that aimed to raise output and income by increasing the supply of money in circulation fie quantitative easing) as "like trying to get fat by buying a larger belt". Nonetheless, a decline in government bond yields would bring welcome relief to bank balance sheets across Europe and reduce the risks of a banking crisis pushing the economy into a deep recession, regardless of whether the policy helps to stimulate domestic demand significantly in the short term.

doi: 10.1177/0027950112219001013

Table 1. Forecast summary Percentage change

 Real GDP (a)

 World OECD China EU-27 Euro USA
 Area

2008 2.8 0.1 9.3 0.2 0.3 -0.3
2009 -0.7 -3.8 8.9 -4.2 -4.2 -3.5
2010 5.1 3.1 10.4 1.9 1.8 3.0
2011 3.9 1.9 9.3 1.7 1.6 1.7
2012 3.5 1.4 8.5 0.1 -0.2 1.9
2013 4.1 2.3 7.9 1.6 1.3 2.7
2002-2007 4.4 2.6 10.3 2.3 2.0 2.6
2014-2018 4.2 2.5 7.5 2.1 1.9 2.5

 Private consumption deflator

 OECD Euro USA Japan Germany France
 Area

2008 2.9 2.7 3.3 0.4 1.7 3.0
2009 0.3 -0.4 0.2 -2.1 0.1 -0.6
2010 1.7 1.7 1.8 -1.6 1.9 1.2
2011 2.4 2.6 2.5 -0.9 2.3 2.2
2012 1.9 2.2 1.9 -0.2 2.0 1.8
2013 1.4 1.2 1.5 0.0 1.5 0.9
2002-2007 2.0 2.2 2.4 -0.8 1.3 1.8
2014-2018 2.2 2.2 2.4 0.7 1.7 1.6

 Real GDP (a)

 Japan Germany France

2008 -1.2 0.8 -0.2
2009 -6.3 -5.1 -2.6
2010 4.1 3.6 1.4
2011 -0.2 3.0 1.6
2012 1.8 0.6 -0.2
2013 1.6 1.9 1.4
2002-2007 1.8 1.4 1.8
2014-2018 1.7 1.7 2.1

 Private consumption
 deflator

 Italy UK Canada

2008 3.1 3.5 1.6
2009 0.0 1.4 0.5
2010 1.5 4.1 1.3
2011 2.8 4.3 2.0
2012 2.8 1.7 1.9
2013 1.5 1.4 1.5
2002-2007 2.6 2.0 1.6
2014-2018 2.9 1.8 2.6

 World
 Real GDP (a) trade (b)

 Italy UK Canada

2008 -1.2 -1.1 0.7 3.0
2009 -5.1 -4.4 -2.8 -10.7
2010 1.4 2.1 3.2 12.4
2011 0.5 0.9 2.4 6.1
2012 -1.3 -0.1 1.9 3.8
2013 -0.2 2.3 2.5 7.7
2002-2007 1.2 2.9 2.7 7.9
2014-2018 1.4 2.6 2.4 5.9

 Interest
 rates (c) Oil
 ($ per
 USA Japan Euro barrel)
 Area (d)

2008 2.1 0.5 3.9 95.7
2009 0.3 0.1 1.3 61.8
2010 0.3 0.1 1.0 78.8
2011 0.3 0.1 1.2 108.6
2012 0.3 0.1 1.0 111.0
2013 0.7 0.2 1.2 113.0
2002-2007 2.9 0.2 2.7 45.6
2014-2018 1.8 0.6 2.6 126.3

Notes: Forecast produced using the NiGEM model. (a) GDP growth at
market prices. Regional aggregates are based on PPP shares.
(b) Trade in goods and services. (c) Central bank intervention
rate, period average. (d) Average of Dubai and Brent spot prices.

Table 2. Standard and Poor's sovereign credit ratings

Country 2007 11-Sep

 Rating Outlook Rating Outlook

Austria AAA stable AAA stable
Belgium AA+ stable AA+ negative
Canada AAA stable AAA stable
Cyprus A positive A- negative
Estonia A negative AA- stable
Finland AAA stable AAA stable
France AAA stable AAA stable
Germany AAA stable AAA stable
Greece A stable cc negative
Ireland AAA stable BBB+ stable
Italy A+ stable A negative
Japan AA stable AA- negative
Luxembourg AAA stable AAA stable
Netherlands AAA stable AAA stable
Portugal AA- stable BBB- negative
Slovakia A stable A+ stable
Slovenia AA stable AA negative
Spain AAA stable AA negative
UK AAA stable AAA stable
United States AAA stable AA+ negative

Country Jan-12

 Rating Outlook

Austria AA+ negative
Belgium AA negative
Canada AAA stable
Cyprus BB+ negative
Estonia AA- negative
Finland AAA watch negative
France AA+ negative
Germany AAA stable
Greece cc negative
Ireland BBB+ negative
Italy BBB+ negative
Japan AA- negative
Luxembourg AAA negative
Netherlands AAA watch negative
Portugal BB negative
Slovakia A stable
Slovenia A+ negative
Spain A negative
UK AAA stable
United States AA+ negative

Source: Standard and Poor's.