A parting of the ways Paul Donovan  ;   Senior global economist, UBS Investment Bank, London

JAKARTA POST,  29 September 2014

                                                                                                                       

The United Kingdom caused a brief moment of concern in financial markets in September. Scotland held a referendum on becoming an independent country. For a few days investors contemplated the possibility of the break-up of one of the world’s more enduring multinational states. The decision went against independence, and the risks associated with separation faded from markets. However, the United Kingdom is not the only parting of the ways that investors need to worry about. Investors need to consider the possibility that the world’s major central banks will pursue opposing policies. In the United States, barring an unforeseen calamity, the quantitative policy of deliberately printing money will come to an end at the October meeting of the Federal Reserve. With that, investors will ask the inevitable question: “what next?” What is next is monetary policy tightening, raising the Fed Funds interest rate from its current 0 percent. When, and how quickly the Fed choses to start raising interest rates will be a source of considerable speculation. Already two members of the Fed dissent from the stable policy majority view (albeit over different facets of that policy). The Bank of England is also experiencing dissent within its ranks. The dissent signals a desire to raise UK interest rates — perhaps as soon as November. This is less to do with the threat of inflation (which remains well contained in the UK), and more about maintaining a balance in the economy. After almost six years of unchanged interest rates, it would appear that the British consumer has forgotten that interest rates can go up as well as down. With consumer spending accelerating, the Bank of England has an incentive to remind the public that there are costs associated with credit. The Anglo-Saxon economies are therefore moving to tighten interest rates, and in the case of the UK that could come as soon as this year. Elsewhere, the eurozone is going in completely the opposite direction. European Central Bank (ECB) president Draghi has crossed the monetary policy Rubicon and taken one of the ECB interest rates negative. While not prepared to make an open ended commitment to buy government bonds, the ECB governing council has committed to expand its balance sheet the “diet” version of quantitative policy. More measures may yet be necessary, as growth remains weak. Meanwhile in Japan, the illusion of Abenomics seems to be losing some of its glitter. Prime Minister Shinzo Abe’s Cabinet approval rating has moved below 50 percent, which both signals a depressed domestic consumer and at the same time makes the political process of achieving reform more difficult. If structural change and fiscal stimulus becomes harder to achieve, the pressure on the Bank of Japan to do even more with regards to its quantitative policy is only likely to increase. How has this divergence of policy come about? The simple answer is “banks”. In the Anglo-Saxon economies the 2008 financial crisis led to swift reform of the banking sector, with banks being required to recapitalize early. While painful at the time, banks in the United States and the United Kingdom are now strong enough that they are cautiously prepared to lend money. The quantitative policy accommodation of past years is finally being put to work in the economy and is stimulating growth. The US economy has exceeded 3 percent annualized growth for three of the past four quarters, and the UK economy is expected to be the fastest growing economy in the G7 this year. In the eurozone, meanwhile, banks are still reluctant to lend — or at least, they are reluctant to lend at a price that borrowers wish to borrow. The ECB’s flood of liquidity is held back by banks that fear the consequences of further regulation and higher capital requirements (under the new regulatory regime of the ECB). Meanwhile, the Japanese banks are willing to lend, but the bias of their new lending is outside of Japan, not inside. Domestic demand in the Japanese economy remains weak as a result. The differences in the Anglo-Saxon banking sectors on one hand, and the eurozone and Japanese banking sectors on the other hand, mean that policy and economic growth divergence is likely to stay in place for some time. Up until now the focus of investors has been on the eurozone, and with that a bias towards policy accommodation. In October and November that mentality is likely to shift. With the Fed and the Bank of England clearly signaling higher policy interest rates, the mentality of the markets is likely to be biased towards policy tightening. If investors think in terms of tightening rather than thinking in terms of more easing, then the implications for financial markets could be felt quite widely. ●