Gavyn Davies

Mario Draghi, ECB chief. Getty Images

Following today’s glut of monetary policy news, markets seem to have temporarily re-assessed their recent bullishness about the euro. However, investors should not lose sight of the fundamental gap that still exists between the ECB’s preference for relatively traditional monetary policy and the aggressively unconventional approach of the other major central banks. That has not gone away.

For example, the Bank of England remains in unorthodox monetary territory, as shown by its willingness to accept, for the first time, that inflation will remain above 2 per cent well beyond the two-year policy horizon. Mark Carney’s Select Committee evidence may have dashed expectations of a nominal GDP target, and he may have sounded lukewarm about more quantitative easing, but overall he remained extremely dovish, especially with regard to Fed-style forward policy guidance. Read more

Worries about global currency wars have resurfaced in recent weeks, mainly because of Japanese action on the yen. This is only the latest of several such flare-ups since the 2008 financial crash. It is hard to avoid the suspicion that the unconventional monetary policies of the US, UK and others are designed to drive down their exchange rates in order to indulge in “beggar thy neighbour” policies of the type which Samuel Brittan has condemned.

Currency wars strike dread into the hearts of most economists because they contributed greatly to the severity of the Great Depression in the 1930s, especially in the worst phase from 1931-33. The damage done to global trade in that period took several decades to repair, and a repeat of this nightmare cannot be entirely ruled out. However, there are very large differences between the policies pursued in the 1930s and what is happening now, and the results may also be very different. Read more

Mark carney takes questions in Davos. Getty Images

Mark Carney’s comments on monetary policy at Davos, though not specifically about the UK, opened a wide gap between his thinking and that of outgoing governor Sir Mervyn King). The latter expressed doubts last week about the ability of monetary policy to boost the economy further, given his concerns about the UK supply side, and his related worries about the 2 per cent inflation target.

At Davos, Mark Carney showed very little sympathy for any of this, arguing that there is plenty of scope for monetary policy to boost the developed economies further, and specifically saying that it might be appropriate to allow inflation to run above 2 per cent for a time in order to achieve this. It would be very surprising if Mr Carney were willing to make such remarks unless he believesthey apply to the UK. Read more

The past few weeks have seen a surge of inflows into US equity mutual funds, following many years in which investors have preferred allocating money to bonds rather than stocks. The week ended January 9 saw the fourth largest weekly cash flow into equity mutual funds since 1992, and large investment companies such as BlackRock have spoken of a sea change in the opinion of small investors towards equities. Some analysts see this as the start of a great rotation from bonds into stocks, thus reversing the pattern of the last decade.

Others, however, point out that cash inflows from small investors tend to be contrarian indicators, since they are often driven by recent market behaviour, rather than by fundamental valuation, which is what actually determines market returns in the long run.

An interesting academic paper has recently appeared on this topic, written by two behavioural economists from Harvard, Robin Greenwood and Andre Shleifer. The paper, which is well summarised here in Free Exchange in The Economist, discusses the signals that can be derived from investor sentiment and flow data, and then contrasts these results with some standard predictions from the theory of finance. Given their results, some unexplained puzzles remain. Read more

Most economists accept that developed economies have been operating considerably below potential GDP since 2008, but there is much less agreement about the size of the output gap, and what should be done about it. This is obviously crucial. The larger the output gap, the greater the waste of resources (and, from an investor’s point of view, the greater the scope for future growth). Furthermore, the larger the gap, the smaller the budget deficit when economies return to potential, so the greater the scope for fiscal expansion today.

Keynesians have been focused on these issues for a while, and have generally had the better of the argument in the current recession. Recently, their thinking has been developing in some important respects. An example is Paul Krugman’s contribution to a panel discussion on the macroeconomics of recessions at the annual meeting of the American Economic Association in San Diego last week. (Brad DeLong, the panel chairman, has posted a transcript). Read more

The macroeconomic debate is now buzzing about “political dominance” over the central banks, under which elected politicians force central bankers to take actions they would not choose to take, if left to their own devices [1]. This is clearly what is happening in Japan, where the incoming Shinzo Abe government is not only imposing a new inflation target on the Bank of Japan (which is legitimate), but is changing the leadership of the central bank to ensure that the BoJ adopts policies compliant with the fiscal regime. This is not just political dominance, it is fiscal dominance, where monetary policy is subordinated to the decisions of those who set budgetary policy.

There have also been some early signs of political or fiscal dominance emerging elsewhere, notably in the use of the ECB balance sheet to finance cross-border financial support operations in the eurozone, and the “coupon raid” conducted by the UK Treasury on the Bank of England. Many investors have concluded that there is now an inevitable trend in place that will overthrow central bank independence throughout the developed world, allowing politicians to expand fiscal policy, while simultaneously inflating away the burden of public debt. Read more

Global equities rose by about 4 per cent last week as the markets breathed a massive sigh of relief about US fiscal policy. Yet merely avoiding the worst of the fiscal cliff is not enough to ensure a satisfactory outcome for the American economy. The fiscal and monetary strategy which has now emerged in the US bears a very close resemblance to the strategy which has been in place in the UK for the past three years. In the case of Britain, the combination of fiscal tightening along with aggressive quantitative easing by the central bank has so far led to economic stagnation.

At first blush, recent events in the UK therefore do not inspire much confidence that the US is now headed in the right direction. But the two economies are not identical, and there are solid grounds for expecting the US to perform better under its newly adopted economic approach than the UK has done. In particular, the US private sector seems to be in much better shape to absorb the effects of fiscal tightening than the UK private sector was in 2010. Read more