PIMCO Warns Global Central Banks Are Now Openly Defecting From The Status Quo's Prisoner's Dilemma
Uncertainty. That has become the key word of the day, the month, and of 2011 in general. And while broad uncertainty has manifested itself most notably in the capital markets, it has a far more practical representation in labor markets, where the main reason why employers are not hiring more people, arguably the primary scourge of the Obama administration's record low approval rating, is due to corporate uncertainty about the future: about taxes, about government demanding its pound of flesh when the time comes, and about the economy in general. Ironically, as PIMCO speculates in its daily note authored by Tony Crescenzi, probably the primary driver of global uncertainty is the increasingly uncoordinated response by monetary policy authorities (read Central Banks) in which where before all had cooperated in the global game theory, now increasingly it is every printer for himself, as the default response turns to one of defection. And as everyone who has studied Game Theory knows, it is only the first defection that provides the biggest return, with each subsequent act generating far less benefits to the uncooperative actor, forcing even more uncooperative irrationality, and so on in a toxic spiral until outright belligerent action develops. For now said belligerence has begun to manifest itself in plain vanilla trade wars, such as that pointed out last night with the Chinese response to Europe's lack of response to its "bailout" overtures, and following up with the just announced complaint filed by the US against China on chicken prices. Naturally this is just the beginning. The real concern is that where trade wars end (which in turn begin when FX wars end), real ones start. When a year ago we first branded the Chairsatan as "genocidal" we were mostly joking. Perhaps it is time to reevaluate our definition, as it is far less comical under the current environment. Here is what Pimco has to say on the issue.
From PIMCO, Ya Gotta Believe, an extract:
Global Competitive Quantitative Easing
In March of 2009, central banks began a campaign against deteriorating financial conditions. When the Bank of England announced quantitative easing, the Federal Reserve and several other central banks, including the Bank of Japan and the European Central Bank, followed suit. In the 1930s, the U.K. abandoned the gold standard, allowing a devaluation of the pound, and several other countries followed with devaluations. They were known as competitive devaluations, since they sought to boost trade. In 2009, major developed economies experienced severe recessions for similar reasons – credit contraction – and so central banks acted in their own interest. Central banks followed each other in a competitive way, absent a coordinated response. And so quantitative easing was dubbed “competitive QE.”
During QEII, U.S. negative real rates together with uncertainty over the Eurozone debt crisis led to a flight out of the dollar and into emerging market currencies as well as perceived “safe havens” like the Swiss franc. Since the dollar remains the reserve currency, negative U.S. real rates present a choice for global central banks to accept or reject a deflationary impulse from real effective exchange rate appreciation. The choice has become more urgent as downward adjusted growth expectations resulting from fiscal austerity combined with financial market stress have heightened the risk of a liquidity trap.
Central banks could respond to a liquidity trap with tools to make their real rates and currencies as unattractive as possible. Recently, the Swiss National Bank did this by announcing an explicit floor on the Swiss franc. The Bank of Japan responded by expanding its asset purchase fund, while Japan’s Ministry of Finance assisted by unilaterally intervening in the Japanese yen. The G-7 released a communiqué advocating close consultation in regard to actions in exchange markets and appropriate cooperation. Next, the European Central Bank coordinated with the Fed, the Bank of Japan and the Swiss National Bank to offer three dollar liquidity auctions until year-end, but that is a stopgap and not a sign of grand cooperation.
In an environment where large fiscal adjustments are required, central banks rely on mechanisms that are effective. Indirectly through asset purchases or liquidity injections, central banks could competitively devalue their currencies. As competition intensifies, cooperation and coordination among global central banks could diminish and engender a timing dilemma for policy reversal. At the same time, decisions may become asymmetrical as central bank actions are not synchronized but rather self-centered. Both cases of Switzerland and Japan showed by targeting the currency in reaction to flight to safety and negative real interest rates, each central bank acted on its own in a non-cooperative manner, contrary to what the coordinated dollar liquidity action suggests.
Figure 2 depicts that along the distribution of the world’s average real policy rates, there is a very wide range of inflation outcomes. As a competitive process in central bank decisions continues, greater inflation volatility increases uncertainty in global economies and financial markets. The following sections in this commentary explore how individual central banks in developed and emerging markets are dealing with this uncertainty.
Read the full thing here.