Developed world short rates and monetary policy

Current economic and financial conditions call for additional easing in most of the developed world, but with rates close to zero and in many cases priced to remain there for the next couple of years, the ability to position for more stimulation through conventional easing is more limited than usual. In the US and Japan, rates have been effectively zero for years. In the UK, rates are below 0.5% (and may remain there even as other forms of easing are pursued). There is a bit of room for more easing than discounted in Canada, as rates are priced in to bottom at 0.75%, but not much. Euroland has more pressure to ease than any other major developed economy, but interestingly, there is some tightening priced in for 2013, which looks unlikely to us. Australia is the only major developed economy with rates not close to zero.
Rates are priced in to bottom at a bit over 3%, though here too, we expect more easing than this to be ultimately required. Of course, these rates are just the rates that banks can borrow at from central banks for relatively short durations. With the recent widening of spreads, the true cost of funds for developed world banks has been increasing as has the cost of credit for other borrowers in the real economy.

Central banks have the ability to pursue other forms of easing, primarily through asset purchases. While they have begun to shift in this direction, their actions in this latest round are still modest. We estimate that the Fed’s twist program is probably the equivalent of about half the pace of asset purchases via QE2 (and much smaller than QE1). The asset purchases in Europe are much more modest in size relative to the Euroland economy (though not as a share of issuance of the individual countries they are purchasing). Japan has done relatively little and focused on short-duration instruments. Only the UK has pursued asset purchases that are larger than the previous round. These purchases are still a very indirect way to get cash into the hands of those who would spend it, so their effectiveness is limited. A more meaningful shift in that direction (particularly relative to the significant need to ease) would benefit asset prices more broadly. Outside the UK, central banks have not done so in a meaningful way in the latest round, though a shift toward additional easing is clearly taking place.

Looking at these issues in a bit more detail, in Euroland, where the interbank rate is priced in to rise about a year out, the effective interbank rate is trading around the deposit rate, which now stands at 0.50%. Prior to the crisis, the interbank rate closely tracked the higher target rate; however, the rate now largely prices off the lower bound, which is what banks earn on their excess reserves at the ECB. As liquidity remains stressed, banks are currently willing to borrow at 1.25% and lend money back to the ECB at 0.50%, for a loss, to acquire the liquidity they desire. The current upward-sloping pricing means that these strains would have to ease and the ECB would have to keep its target rate roughly where it is. We expect that the likely prolonged period of European de-leveraging will actually require more aggressive easing, keeping rates low for a prolonged period.

While central bank target rates have been lowered to close to zero and are priced in to remain there, rising spreads mean that the cost of credit to the economy has actually increased. The recent widening, while smaller than 2008, is reflective of tightening credit conditions and longer-term bank spreads have widened more than short term cash spreads.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla