The Fed’s decision about purchases of new securities to ease monetary policy was the key development in the external arena last week, while at home the focus was on the news regarding the delay of the fiscal rule, which would not be ready for 2011 budget and which would be subject to parameter changes.
Let’s start with looking into the Fed decision first: The Bank announced that they would reinvest principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities so that the Federal Reserve's holdings of securities would be kept constant at their current level. The Fed had purchased some US$1.25trn of mortgage-backed securities and some US$175bn of other agency debt. Considering that Fed had previously planned to gradually narrow their security portfolio in the context of exit strategy, this new decision pointed to a looser monetary stance. Recall that in testimony to U.S. Congress in July, Fed Chairman Bernanke had outlined several options available to Fed if the “recovery seems faltering”: Further changes or modifications to their language on interest rates strategy, lowering the interest rate they pay on excess reserves and changes in their balance sheet - either not letting securities run off or making additional purchases. Therefore, Fed’s decision to activate one of these options implied that the Fed sees the economic recovery as faltering. In essence, Fed also downgraded their assessment of the economic outlook in the FOMC statement. The key developments, in our opinion, that urged the Bank to change monetary stance were the non-farm payrolls and unemployment rate. After the job losses reached 8.3 mn, accompanied by the unemployment rate peaking at 10.1%, the labor market indicators have improved somewhat. However, over the last months, the increase in private payrolls and the decline in unemployment rate have cut pace. After the FOMC meeting, the 10-year U.S. Treasury yield slumped to 2.7%, the lowest of the year (vs. the historical low of 2%), while rate hike expectations have been postponed towards 2012 in the Fed fund futures. This outlook may be an important indicator that the interest rates would remain low across the globe for longer-than-expected.
As opposed to this external support for low interest rate environment, the news at home that the fiscal rule would not be applied for 2011 budget brought the risk of erasing the positive repercussions. The Central Bank had said they monitor fiscal policy developments closely while formulating monetary policy and that the fiscal space created by the stronger-than-expected economic activity leading to better-than expected performance in budget revenues should be used mostly to reduce the government debt stock. The Bank also had noted that should the fiscal discipline implemented through institutional and structural improvements, such as enacting and establishing the fiscal rule, it would be possible to keep policy rates at single-digit levels over the medium term. Despite the Bank’s sensitivity to this issue, it is not straightforward to assume that the recent developments regarding the fiscal rule would yield a change in monetary policy stance. Given the fact that the monetary policy did not even react to the substantial deformation in budget vs. the targets during the crisis, it is not easy to speculate whether this time would be different. A possible scenario may involve the Bank saying that they would continue monitoring how the fiscal space created by higher-than-expected revenues would be spent. If they chose to do so, they may later say they are satisfied with the 2011 budget being prepared with respect to the framework described in the previous MTP. Finally, they may even end up saying that “the fiscal rule would have been better, yet the implementation is more important.”
The best we can do now is watching the current trend in the fiscal outlook on one hand and on the other hand to dig into the budget targets for 2010-2012 to be described in the MTP due out in September ahead of the submission of the 2011 budget to the Parliament’s approval on October 17th. Glancing at the performance as of June, the 12-month rolling central government budget deficit to GDP ratio, which is the best indicator for trend, declined to 4.3%, accompanied with 0.9% primary surplus (0.5% primary deficit in IMF defined figures). This picture guarantees that the deficit would remain below the 4.9% target by the year-end even in the absence of any y/y improvement. Our guess is that the deficit would regress to 3.7%, assuming that there would be no additional expenditure burden. To put it differently, meeting the official year-end target for the deficit or surpassing the levels mentioned above would simply imply deterioration for the second half of the year.
No doubt, when the new MTP is disclosed, the target for 2010 budget deficit should be expected to be revised down on the back of upgraded growth forecasts (to 5.5% or 6.0% from 3.5%). The extent of revision is important, yet more important than that would be whether the 2011 and 2012 deficit targets (4.0% and 3.2%) would be modified. For example, if the long run targets of 1.0% budget deficit and 5.0% GDP growth in the fiscal rule were applied, the budget deficit would have to be brought down to 3.1% in 2011 and to 2.8% in 2012, based on our 3.7% estimate for 2010 budget. Therefore, in essence, the officials’ announcements that the budget would be prepared in line with the MTP indicate at a looser fiscal stance than the original framework assumed when the MTP had been first disclosed last year, as the 2010 outlook is much better than the targets.
Upon the news regarding the delay of the fiscal rule, the rating agencies ruled out direct linkage between the fiscal rule and ratings, as expected. Yet they raised concerns regarding the credibility of the government in the absence of the rule, while underscoring that the implementation is more important than the fiscal rule itself, so that the patterns of budget deficit and debt/GDP ratios going forward would be important for the ratings.
In conclusion, the perceptions regarding the growth outlook have deteriorated after the Fed decided to keep constant the security portfolio size, which was one of the alternative measures previously outlined by Fed Chairman Bernanke, should the economic recovery falters. Meanwhile, Fed’s decision has also created an appropriate background for the interest rates to remain low for longer than expected. The news regarding the delay of the fiscal rule at home has the risk of jeopardizing the interest-rate-friendly atmosphere. Nevertheless, the Central Bank seems unlikely to develop a monetary policy response against this despite their previous emphasis on the importance of fiscal rule. The Bank may prefer to monitor the budget outcome for some more time. The rating agencies also tend to favor a similar approach.
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