Monday, 2 June 2014

Central Bank Communication: No Place To Stand

The following is a presentation that I made at the Canadian Economics Association Annual Meeting in Vancouver on May 31, 2014. The presentation was my opening comment on a panel discussion, sponsored by the Centre for International Governance Innovation (CIGI) and chaired by Paul Jenkins, former Senior Deputy Governor of the Bank of Canada. The topic for the panel was "Critical Challenges Facing Central Banks: Independence, Remit, and Communications". The other panelists were Paul Beaudry, Vancouver School of Economics, University of British Columbia; Douglas Laxton, International Monetary Fund; and Pierre Siklos, Wilfred Laurier University.

Good morning. It was a pleasant surprise when Paul Jenkins asked me to be on this panel. I have written a lot in my career about central bank behavior, especially that of the Bank of Canada.

I have done this from various vantage points:

First, as research director at the CD Howe Institute where I worked with Tom Courchene and Peter Howitt on their reviews of Canadian monetary policy in the 1980s.

Second, as Chief Canadian Economist for JP Morgan, where I worked with economists around the world to forecast global growth, inflation, interest rates and exchange rates.

Finally, as Managing Director of OMERS Global Macro Portfolio, where I headed up a team of strategists and traders whose objective was to invest in global stocks, bonds, commodities and currencies to achieve solid risk adjusted returns for the pension plan.

In all of these positions, it was important to understand the objectives and policy framework of central banks. At the CD Howe, my objective was to help provide policy analysis for public debate. At JP Morgan and OMERS, my objective was to apply that understanding to make money for clients or pensioners. 

After more than 30 years of watching monetary policy, I must say that today, I find it more challenging than ever. 

In this presentation, I will outline my views on the challenges facing central bank’s in establishing their remit, communicating their conduct of policy and protecting their independence.

I will illustrate my case with quotations from central bankers who have reflected on these issues over the past 35 years.

For a start, this quote is from a 1982 speech titled “A Place to Stand” by former BoC Governor Gerald Bouey near the end of his term which had been highlighted by the adoption of monetary targets.

Bouey said that the BoC adopted monetary targets in the hope that they would provide “a better place to stand against the constant pressures…for easier money and lower interest rates”.

In his speech, he outlined how financial innovation had caused instability in the demand for money with the result that monetary targets failed to provide a clear place to stand, from which the central bank could communicate how and why monetary policy actions were being taken and thereby maintain its independence. 

Before I get ahead of myself, I would like to explain how I understand, remit, communication and independence:

So let’s start with the remit, using the BoC as an example. The remit is the currently agreed upon interpretation of the BoC’s mandate which was laid out in the Bank of Canada Act of 1935.

As I read it, the original mandate tasked the BoC with three objectives:
  • To regulate credit and currency;
  • To control and protect the external value of the C$; and
  • To mitigate fluctuations in output, trade, prices and employment. 
Gerald Bouey explained in his 1982 speech that, up to that time, the Bank of Canada’s interpretation of its remit had gone through three stages.

Since his speech, I would argue, there have been two more re-interpretations of the remit.

The Clean Doctrine was based upon a view presented by Fed Chairman Alan Greenspan at the Jackson Hole conference in 2002, which held that:

During Inflation Targeting I, the BoC contended that hitting the inflation target was the preeminent objective of monetary policy. As BoC Governor Thiessen said in 1997, achieving the inflation target was “the best contribution that monetary policy can make over time to a well-functioning economy – an economy that delivers growth in output and employment”.

Bank of Canada communication during Inflation Targeting I consistently hammered home this message. This quote from BoC Governor Gordon Thiessen was repeated in various forms in many speeches throughout his term and that of his successor, David Dodge.

Governor Dodge’s quote from a 2003 speech makes it crystal clear that the BoC agreed with the Clean Doctrine. The BoC saw its remit as using the policy rate to stabilize inflation around the target. It did not believe that it should target asset prices or attempt to lean against or pop asset bubbles. 

Another feature of BoC communication in the Inflation Targeting I era was the strong suggestion that the milder recessions and generally the reduced volatility of real output since the early 1990s – which came to be known as the Great Moderation – was, in large part, the result of the success of Inflation targeting in delivering low and stable inflation. This quote from a 2006 speech by BoC Deputy Governor David Longworth makes the point. 

David Longworth's quote is very similar to a statement made in a 2004 speech by then Fed Governor Ben Bernanke entitled “The Great Moderation”, in which Bernanke said, “improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation but to the reduced volatility of output as well… This conclusion on my part makes me optimistic for the future." (Ben Bernanke, “The Great Moderation”, February 20, 2004).

One year after Longworth’s speech came the Great Financial Crisis – the worst episode of financial and macroeconomic volatility since the Great Depression. 

Central Banks that had adopted Inflation Targeting and the Clean Doctrine were challenged to clean up the mess. Policy rates fell to the lower bound in many countries and central banks adopted unconventional instruments including quantitative easing, credit easing, and forward guidance.

This quote by BoC Governor Mark Carney highlighted the shortcomings of the Inflation Targeting I and the Clean Doctrine.  

Carney argues that low and stable inflation combined with central bank promises to mop up the mess can actually sow the seeds of powerful financial instability which can lead to instability of output and inflation. It appears that adopting the Clean Doctrine had fueled risk-taking behavior and exacerbated the crisis. 

In Canada, the Inflation Targeting remit of the BoC was due for review and renewal in 2011 and this ushered in the era of Inflation Targeting II. Some refer to this new remit as Flexible Inflation Targeting. The three key elements of the remit are shown in this slide.

The significant change is contained in the third bullet. It suggests that the goal of returning inflation to the target may occasionally be altered to support financial stability. It suggests that the BoC may decide to utilize the policy rate to lean against possible asset price bubbles, which might lengthen (or shorten) the projected time path of inflation back to the target level.

The difficulty with this change is that the BoC now has two stated goals – price stability and financial stability – but only one instrument, the policy rate.

What is equally worrisome, is that the validity of the analytical framework employed by the BoC to communicate and explain its decisions during the Inflation Targeting I era is increasingly in doubt.
The first quote below, from 2006 by Governor David Dodge, lays out the simple Aggregate Demand-Aggregate Supply framework that has been the centrepiece of BoC communication since the inception of inflation targeting.

The second quote from 2014, by outgoing Senior Deputy Governor Tiff Macklem raises serious doubt about the usefulness of the domestic AD-AS framework based on the output gap. Macklem’s speech pointed out that the dominant determinant of Canadian Total CPI Inflation is not the output gap but Total Global Inflation. Domestic factors are more important in determining Canadian Core CPI Inflation, but the coefficients on the determinants of core inflation are too small and statistically insignificant to be realistic guides to policy.

What are the implications for central bank independence? It is my contention that central bank independence is granted by the elected officials who form the government but that, once granted, independence must be continuously earned by successful execution of the central bank’s remit.

This chart from a paper by former Fed Vice-Chairman Donald Kohn shows US polling results on the public’s confidence in Fed. 

In 2007, before the GFC, over 50% of the public said they had a great deal or a fair amount of confidence in the Fed, while only 25% said they had only a little or almost no confidence. By 2012, almost four years into the recovery, just 39% said that they had a great deal or a fair amount of confidence, while 47% said that they had little or no confidence.

This explains why the Fed has been concerned about threats to its independence.

Ben Bernanke, speaking in Toronto in April 2014, made this quote:

Even though the Bernanke Fed must be given much credit for the steps it took during the GFC to avert a much bigger financial collapse, this quote is evidence that the consensus on the central bank remit, the clarity of the communication of monetary policy, and the independence of the Fed and other central banks have suffered.

I close with this slide.

Tinbergen’s Rule holds that consistent economic policy requires that the number of instruments equal the number of targets. More targets than instruments makes targets incompatible. More instruments than targets makes instruments alternative; that is, one instrument may be used instead of another or a combination of others.

Central Banks have been tasked with multiple objectives, not just price stability. They have innovated through the increased use of non-conventional instruments. In the process, they have not kept a clear identification of which instruments are to be used to pursue which targets. In addition, some of these instruments were never intended to be wielded independently by central banks, especially those involving private asset purchases and macro-prudential policies.

The world is much more complicated than it was widely believed to be during the Inflation Targeting I era. Like Gerald Bouey in 1982, I would conclude that unfortunately, inflation targeting has not provided the clear place to stand for which some had hoped.      



Sunday, 1 June 2014

ETF Portfolios for Canadian Investors: May Review and June Outlook

Global markets for equities and bonds moved higher in May providing good gains for diversified portfolios. This was true despite a continued rally in the Canadian dollar (CAD) versus the USD, which subtracted from most foreign currency denominated ETF returns in May.  

  • Global equity markets rebounded in May. US small-cap and tech stocks, as well as Japanese equities, which all sold off sharply in April, recovered some lost ground. US large cap, Canadian and European equities posted gains.
  • Global bonds continued to rally in May, with Canada bonds outperforming foreign currency bonds in CAD terms. 
  • Emerging Market assets recovered further in May, as Ukraine held elections and Putin said he would negotiate with the new leadership. 
  • Gold and commodity ETFs posted losses in May. 
  • Energy prices firmed as the WTI crude oil futures price rose to $103/bbl at the end of May from $100/bbl at the end of April.
  • Global growth forecasts for 2014 continued to be revised down, led by a downward revision to US real GDP, which now shows a contraction in Q1.  
  • Global inflation showed mixed signals, with inflation looking as if it firming in the US and Canada, but still weak in Europe and China.

On the central bank front, the US Fed indicated that it plans to continue to taper its QE program despite negative Q1 growth. Fed Chair Janet Yellen maintains that policy rates will remain at the current low level as long as slack remains in the labor market. Members of the FOMC remain widely divided on how soon and how much the policy rate should be raised. 

The ECB appears to be edging closer to some new form of policy easing. The BoJ reaffirmed its intention to continue to implement its massive QE program. China’s PBoC appears to be considering its own form of Quantitative Easing even though it has ample room to lower its policy rate.

The previous tailwind of a weaker Canadian dollar for Canadian investors in global ETF's continued to reverse in May. Bank of Canada Governor Poloz continues to signal increased confidence in a soft-landing for Canada’s inflated housing market and no interest in tightening monetary policy any time soon.

Global Market ETFs: Monthly Performance for May

The S&P500 closed May at a record 1924, up from 1884 at the end of April and 1842 at the end of December. Global equity ETFs posted decent returns in May. The C$ strengthened 1.0% vs. USD in May, lowering Canadian dollar returns on USD denominated ETFs. Japanese equities (EWJ) provided the strongest returns among the equity ETFs we track, gaining 3.4% in CAD terms. Emerging Market equities (EEM) returned 1.9%, US Large Cap (SPY) returned 1.2%, Canadian equities returned 1.1%, and Eurozone (FEZ) returned 0.3%. US small caps (IWM) posted a loss in May, returning -0.3% in CAD terms.

Commodity ETFs lost ground in May. The Gold ETF (GLD) returned -4.1% in CAD terms, while the GSCI commodity ETF (GSG) returned -1.6%.

Most global bond ETFs turned in solid performances in May. ETFs with positive returns included Canadian Long Government bonds (XLB), which posted a 2.6% return, USD-denominated Emerging Market bonds (EMB) returned 2.4% in CAD terms, the US long government bond (TLH) 1.1%, and Emerging Market Local Currency bonds (EMLC), posted a 1.1% return in CAD terms. Non-US government bonds (BWX) underperformed, returning -0.9% in CAD terms, as peripheral European bonds weakened.

North American inflation-linked bonds (ILBs) posted positive returns in May as inflation showed more signs of turning up. Canadian RRBs (XRB) returned +2.6%, while US TIPs (TIP) returned +0.9% in CAD terms. Non-US ILBs (WIP) returned +0.04%.

Corporate bonds underperformed government bonds in May as US investment grade (LQD) and high yield (HYG) bonds returned 0.4% and 0.1% respectively. Canadian corporate bonds (XCB) returned +1.1%.

Year-to-date Performance through May

In the first five months of 2014, with the Canadian dollar depreciating 2.0% against the US dollar, the best global ETF returns for Canadian investors were in Emerging Market bonds (EMB) and US long bonds (TLH). The worst returns were in Japanese equities (EWJ). 

In global equities, the Eurozone equity ETF (FEZ) performed best, returning +7.2% year-to-date (ytd) in CAD terms, initially on signs of improved growth and lately on indications that the ECB will ease monetary policy to combat persistently low inflation. The Canadian equity ETF (XIU) performed well, returning 6.0%. The S&P500 ETF (SPY) returned 6.4% in CAD terms. Emerging Market equities (EEM), suffering from Fed tapering, political turmoil, and China’s growth slowdown, returned 3.8% ytd in CAD terms. The Japanese equity ETF (EWJ), hit by Yen strength and slowing Asian growth, returned -2.8%. US small caps (IWM), after a sharp selloff in April, returned -0.3% ytd. 

Commodity ETFs, which had been among the strongest performers through April, gave back some of their gains in May, partly reflecting renewed firmness of the C$. The Gold ETF (GLD) returned 5.7% ytd in CAD terms, while the iShares GSCI commodity ETF (GSG) returned 4.9%.  

Global Bond ETFs, contrary to consensus expectations at the beginning of the year, performed extremely well in the year-to-date through May. Bond ETFs have benefited from a combination of weaker than expected economic growth, lower than expected inflation and safe haven demand. The US long bonds (TLH) returned +8.2% in USD terms, but with the 2% depreciation of the C$, this translated into a +10.3% return in CAD terms. USD-denominated Emerging Market bonds (EMB) returned +10.7%. The Canada Long Bond ETF (XLB) posted a gain of +7.3%. Non-US global government bonds (BWX) posted a return of +6.2% in CAD terms. Emerging Market local currency bonds (EMLC) suffered from the same problems as EM equities earlier in the year, but still returned 6.5% in CAD terms. 

Inflation-linked bonds (ILBs) have rebounded the first five months of 2014 after a disastrous performance in 2013. The Canadian real return bond ETF (XRB) fared best, benefiting from its long duration, returning 9.2% ytd. Non-US ILBs (WIP), returned +8.1% in CAD terms, while US TIPs (TIP) returned +7.5%.

In corporate bond space, the US investment grade bond ETF (LQD) returned 8.0% ytd in CAD terms, while the US high yield bond ETF (HYG) posted a return of 6.3% as high yield spreads widened. The Canadian corporate bond ETF (XCB) returned +3.5%.

Global ETF Portfolio Performance through May

In May, the Canadian ETF portfolios tracked in this blog posted decent gains, adding to positive year-to-date returns.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio gained 91 basis points in April to be up 5.9% ytd. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 66 bps in May to be up 4.9% ytd.

Risk balanced portfolios also posted good gains in April. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 106 bps in May, boosting to its year-to-date gain to 10.7%. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit and emerging market bonds, returned 70 bps in April to be up 6.8% ytd.

Outlook for June

After sharp sell-offs in US small cap and technology stocks in April, global equity markets steadied and recovered in May. While 1Q14 US and global growth were very disappointing, markets have maintained confidence that that the 1Q stumble reflected bad weather and other anomalies and that growth will bounce back over the remainder of the year.

What has puzzled investors is the sustained strength of global bond markets, even as equities have regained some momentum. In May, mixed economic data combined with signals from ECB President Draghi that it was prepared to take more measures to ease monetary policy further, supported Developed Market bonds. Reassurances from Fed Chairman Yellen that the Fed would not consider raising the Fed funds rate until economic slack has subsided substantially further, also helped, especially in Emerging Markets. 

Key developments that Canadian ETF investors should be watching in June include:

  • Ukraine remains a source of geopolitical risk, but Putin’s apparent willingness to negotiate with the new government has tempered concerns for now. Any sign that such negotiations will not lead to de-escalation of tensions in East Ukraine has the potential to upset markets in June. 
  • The Bank of Canada, with its policy rate decision on June 4 will likely reconfirm that the direction of the next rate move will depend on growth and inflation developments. Inflation ticked up in April, but 1Q14 growth, at 1.2% was well below expectations. Downside risks on inflation may have eased slightly, but the BoC will avoid any talk of tightening.
  • After a weak 1Q14, US and global growth need to show signs soon that the stronger growth built into equity prices is emerging. If the global economy fails to reaccelerate, the May rebound in equity markets could quickly reverse. If the strong reacceleration emerges, it is hard to believe that bond markets will be able to hold on to their stellar year-to-date gains.
  • Concerns about low global inflation continue, highlighted by the expected ECB easing and indications that China is looking at new monetary tools to ease policy without reflating the housing bubble.
  • Emerging markets ETFs steadied in May, but continue to lag returns on comparable DM ETFs. Russia-Ukraine tensions appear to have eased. India’s election has sparked optimism about structural reforms. The World Cup will focus attention on Brazil in June. The question for active investors is whether the all-clear sign should now be waved for EM ETFs?

Last month, I concluded that the with setback to momentum stocks in April, “the risk now is that stronger economic growth reverses the bond market rally and, at the same time, equity multiples reverse. Having ample cash in the portfolio was a prudent strategy in April and remains so in May”.

As it turned out, major equity and bond markets rallied further in May as global uncertainties eased and global economic data was mixed. Holding cash was a drag on returns in May. Evidence of a pickup in global growth is still badly needed. US corporate earnings growth slowed in Q1, so the gains in the S&P in May pushed equities further into overvalued territory. The twin risks remain: either stronger economic growth reverses the bond market rally or further disappointment on growth reverses the equity rally. Having ample cash in the portfolio was a prudent strategy in May and remains so in June.