Summary: The financial markets, being convinced that a new phase of quantitative easing would be launched, have started to search for a new equilibrium. The ultra loose monetary policies in developed countries triggered intervention in F/X markets and other measures to discourage capital inflows in many countries, giving the impression of currency wars across the globe. The Central Bank has been prepared to take action to secure financial stability, bearing in mind that this new conjuncture may result in volatility in financial markets. It remains to be seen whether new measures for price stability would also be introduced.
The post-crisis economic backdrop seems to have entered into a new phase of unconventional monetary easing, or more specifically the second round of quantitative easing (QE2). This tool has been especially preferred by developed countries which experience slow economic recovery after the recession and who have already cut policy rates to rock-bottom levels. In September meeting, Fed put greater emphasis on deflation risk and has become the first Central Bank that signaled for expansion in its balance sheet. Moreover, the remarks by a number of Fed officials since then have further fueled into the expectations that Fed would launch QE2 as early as the November 3rd meeting. Japan also joined this camp by lowering the policy rate to 0.0-0.1% range, accompanied with additional asset purchase program. These decisions that would further boost already abundant global liquidity have started to drive the financial markets to a new equilibrium. The Fed’s relative position in terms of monetary policy stance has deteriorated due to their bias for ultra loose monetary policy, consequentially dragging US$ lower across all currencies. The 2-year U.S. Treasury yield slumped to a record low of 0.4%, with the market seeming more deeply convinced that the interest rates would remain low for an extended period. This has also formed the basis for growing appetite for riskier assets. Especially the stock markets across the globe and the emerging market assets in general have become the beneficiaries of this new environment, with the repercussions in Turkey being lower F/X basket and $/TRY, as well as tighter yields along the curve and record highs in stock market. The Central Bank names the key features of this new economic conjuncture as the ‘occurrence of the risks of overheating, excessive indebtness and emergence of asset bubbles as a result of intensive capital inflows towards reliable and dynamic emerging market economies, and the probability of elevated levels of current account deficit threatening financial stability.’ The Bank also says that the additional measures they have taken recently are preparation for the new economic situation, which would dominate the whole world in the upcoming period.
Note that the markets have got very much accustomed to the idea of additional expansion in Fed’s balance sheet (which has expanded to $2.3trn from $860bn prior to the crisis) so that they were not surprised to hear some Fed officials giving details regarding how QE2 would operate. A good example was the speech by Brian Sack from the NY Fed about “Managing the Federal Reserve's Balance Sheet" where he outlined five policy questions that could be considered in designing a purchase program. Sack emphasized that asset purchases that would enlarge the balance sheet should be seen as a substitute for the changes in federal funds rate. The key points in Sacks speech were:
1) Similar to the manner in which the FOMC has historically adjusted the federal funds rate, the balance sheet should be adjusted in relatively continuous but smaller steps, rather than in infrequent but large increments.
2) The balance sheet decisions should be governed to a large extent by the evolution of the FOMC’s economic forecasts just was the case for the decisions regarding the federal funds target rate.
3) The movements in balance sheets should be stressed to have some persistency in order to make them more influential.
4) Providing information about the likely course of the balance sheet could be desirable, similar to the case for federal funds rate.
5) Some flexibility should be incorporated into the program, providing some discretion to change course as market conditions evolve and as more is learned about the instrument.
Note that the ultimate goal of the QE2 is to change the yield curve and revive the economic activity through the banking sector. While doing this, Fed is likely to expand the balance sheet gradually and in small amounts, rather than a substantial and front-loaded approach of the earlier round of asset purchases. While the BoE is foreseen to mirror the steps of its peers BoJ and Fed, the implications of this new round of monetary easing on other Central Banks should be discussed as well. This may urge those Central Banks who have already moved forward with some tightening to give a second thought to their decisions. Moreover, the appreciation of emerging market currencies would potentially have favorable repercussions on inflation with some lag and that could create room for monetary easing maneuvers in some countries, considering also that the risk premiums would remain low in such environments. Ironically, going forward, macroprudential tools may be used more intensively for the sake of financial stability while at the same time a loose monetary policy stance may be adopted to address the price stability objective.
The key question would be whether Turkish Central Bank would also join this camp. Despite the jump in the headline CPI in September, core indices remained below the medium term targets. Moreover, the leading economic activity indicators hinted at some slowdown going forward. These were the developments that supported the Central Bank to at east keep the current monetary policy stance for a longer time. However, it is yet early to conclude whether the fresh developments would be enough to induce the Central Bank for a remarkably change in their baseline scenario that includes limited rate hikes in 2011. We will keep monitoring the signals regarding such a change.
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