Gavyn Davies

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

Many year-end reviews of market behaviour in 2012 have rightly argued that the role of the central banks has once again proven critical, trumping all other factors, including the state of the global economic cycle. In fact, two brief statements by ECB President Mario Draghi have been the decisive events in the global financial system this year.

The first, which actually took place in the early hours of a eurozone summit on 9 December 2011, was Mr Draghi’s favourable assessment of the latest political moves towards fiscal union. This unleashed the ECB’s Long Term Refinancing Operations in the first half of the year. The second, on 26 July 2012, came when Mr Draghi said that the ECB would do “whatever it takes” to keep the single currency intact. This led to the launching of the Outright Monetary Transactions programme in September. Although still unused, the mere possibility of unlimited ECB bond buying in Spain and Italy via the OMT was enough to produce a powerful rally in global risk appetite, despite mounting concerns about the US fiscal cliff.

Understanding the developing attitude of the central banks, and the effects of their actions, obviously remains central for investors in all financial assets. The “big picture” for global financial assets, involving very low government bond yields and a gradual shift of risk appetite into credit and equities, is unlikely to change until one of two events takes place.

The first would be a decision by the central bankers themselves that the era of unlimited quantitative easing must end, either because of the risk of inflation and asset price bubbles, or because of concerns about fiscal dominance over the monetary authorities. The second would be a realisation by the markets that further action by the central bankers is irrelevant because they have run out of effective ammunition. Either of these events would probably remove the central prop from the equity bull market which began in March, 2009, but neither seems very likely in 2013. Read more