Statement on Monetary Policy – February 2009
International and Foreign Exchange Markets
At the time of the last Statement, international financial markets were extremely dislocated following the collapse of Lehman Brothers. Volatility was at historical highs in most markets and there was a widespread sapping of public confidence in the financial systems of several major economies, as well as between financial markets participants. This period of extreme dislocation lasted until late November. Since then financial markets have begun to respond to a large number of government and central bank measures aimed at stabilising the financial system and supporting economic activity. However, confidence in financial markets remains fragile, with significant concerns remaining about the quality of bank balance sheets as a result of the weakness in the global economy.
Central bank policy actions
Since the time of the previous Statement, central banks in both developed and emerging markets have eased monetary policy as the outlook for economic activity has deteriorated further and inflationary pressures have subsided. In the major economies, central banks have lowered policy rates significantly (Table 2). With policy rates at or near zero in a number of cases, central banks have implemented new measures, and modified existing ones, with the aim of addressing the ongoing problems experienced by financial markets.
In the United States, the Federal Open Market Committee (FOMC) lowered its policy rate from 1 per cent to a target range of 0 to ¼ per cent. This has taken the cumulative reduction since the onset of the financial crisis to over 500 basis points. In its statement, the FOMC said that the federal funds rate is likely to remain at exceptionally low levels for some time in light of the further deterioration in economic conditions, moderation in inflationary pressures and continued strains in financial markets. In line with these developments, markets expect the policy rate to remain near zero in the period ahead.
Despite the significant easing in monetary policy, mortgage rates in the United States were still at elevated levels in late 2008 (Graph 15). In part because of this breakdown in the transmission mechanism, the Fed has shifted the focus of its policy actions towards measures it describes as ‘credit easing’. The Fed has emphasised that it is the composition of its balance sheet, rather than its overall size, that is important for the policy objective of supporting credit markets and economic activity, in contrast to the Japanese policy of quantitative easing, which was in place in the early 2000s.1
In this regard, in early January, the Fed started buying Agency-guaranteed mortgage-backed securities (MBS) outright as part of its program, announced in late November, to purchase up to US$500 billion of these securities and US$100 billion of bonds issued by Agencies. The program is intended to increase the availability and reduce the cost of housing credit. Mortgage rates have declined somewhat since this program was announced but nonetheless remain elevated relative to the policy rate (see Box B). Moreover, conditions in the US residential mortgage market – the trigger for the current financial turmoil – have deteriorated further, with both delinquencies and foreclosures continuing to rise and property prices falling further (Graph 16).
This MBS-purchasing program follows the introduction of other Fed facilities designed to support the commercial paper market. Demand for these facilities has grown and has had some success in restoring conditions in the commercial paper market, with issuance in that market improving in recent weeks. In contrast, demand for US dollars via repurchase agreements, the Term Auction Facility, the Discount Window and the Primary Dealer Credit Facility has recently fallen, as has demand for US dollars under the Fed’s co-ordinated swap facility with other central banks (see below). These developments are consistent with some improvement in short-term money markets.
In conjunction with the US Treasury, the Fed has announced the introduction of the Term Asset-backed Securities Loan Facility (TALF), by which it intends to support lending to consumers and small businesses by purchasing up to US$200 billion of newly originated asset-backed securities (ABS) collateralised by auto and student loans, credit card receipts and certain small business loans. The US Treasury has committed US$20 billion of Troubled Asset Relief Program (TARP) funds to the program in order to provide credit protection to the Fed by absorbing the first losses.
In the euro area, the European Central Bank (ECB) has reduced its policy rate on three occasions since the previous Statement, lowering rates by a cumulative 175 basis points to 2 per cent (Graph 17). Market participants currently expect further reductions of 50 basis points over the next few months. The ECB has announced that it will continue to provide as much liquidity as demanded through its regular open market operations, which will continue as fixed-rate auctions until at least the end of March 2009.
The Bank of Japan (BoJ) reduced its policy rate by 20 basis points in December to 0.1 per cent, where it is expected to stay for the period ahead. The BoJ has also introduced several measures to facilitate corporate financing. These include: expanding the list of corporate debt that can be used as collateral in the BoJ’s market operations; introducing new term-funding operations that offer unlimited amounts of funding for up to three months against corporate debt collateral; and buying commercial paper outright. In addition, the BoJ has increased its outright purchases of an expanded range of Japanese government bonds and has decided to resume its purchases of equities from banks.
In the United Kingdom, the Bank of England (BoE) has lowered its policy rate on three occasions since the previous Statement by a total of 300 basis points to an historic low of 1½ per cent (Graph 18). The BoE noted that credit availability had tightened further and that inflationary pressures have continued to ease as the United Kingdom’s economic downturn has gathered pace. Despite a cumulative easing of 425 basis points since December 2007, borrowing rates have fallen by considerably less. Currently, the market expects a further 50 basis point reduction in the BoE’s policy rate over the next few months. With its policy rate falling to such low levels, the BoE has announced that it too is considering a number of additional measures it might take to address the financial dislocation, including the direct purchase of up to £50 billion of a range of assets including debt issued under the Government’s guarantee, other commercial paper and corporate bonds, syndicated loans and a limited range of ABS. The Special Liquidity Scheme, under which financial institutions could swap illiquid assets for government securities, ended as planned at end January, although the term of swaps under the Discount Window has been extended from three months to one year for an additional fee of 25 basis points.
Policy rates have also been lowered elsewhere in Europe in response to the deteriorating outlook for economic activity and abating inflationary pressures. The Swiss National Bank cut rates by a cumulative 200 basis points to ½ per cent. It said it was contemplating a number of additional forms of stimulus including intervening to put downward pressure on the Swiss franc. Sveriges Riksbank reduced rates by 175 basis points in December, taking its policy rate to 2 per cent, while the central banks of Norway and Denmark cut rates by a cumulative 225 basis points and 250 basis points, respectively, to 2½ per cent and 3 per cent.
The Bank of Canada (BoC) and the Reserve Bank of New Zealand (RBNZ) lowered their policy rates by 125 basis points and 300 basis points, to 1 per cent and 3½ per cent, respectively. Further reductions in rates are expected from both central banks, with the market anticipating that the BoC will cut rates by 50 basis points, and the RBNZ by 100 basis points, over the next six months. Both these central banks have introduced new term-funding facilities and the RBNZ has expanded the list of eligible collateral for its domestic market operations to include government-guaranteed securities, and certain corporate and asset-backed securities.
Central banks in many emerging markets have also eased policy (Table 3). The People’s Bank of China has eased policy twice since the previous Statement, reducing its lending and deposit rates by 135 basis points to 5.31 per cent and 2.25 per cent, respectively. It has also reduced its reserve requirement ratio to 15½ per cent for large banks and 13½ per cent for small banks. The central banks of Brazil, Chile and Mexico cut interest rates for the first time since the onset of the financial crisis after they judged that inflationary pressures had eased. Other emerging market central banks that have cut rates include those of the Czech Republic, Hungary, India, Indonesia, Israel, Korea, Malaysia, the Philippines, Poland, South Africa, Taiwan, Thailand and Turkey. In contrast, the Russian central bank has tightened policy twice since the previous Statement, attempting to stem capital outflow and to mitigate downward pressure on the exchange rate.
Central bank actions designed to ease tensions in offshore markets for US dollars appear to be proving successful, with the amount of US dollars provided to other central banks under the Fed’s swap facility declining since early December.2 By early January, several central banks – including the RBA – were receiving no bids in some of their US dollar auctions. Nonetheless, the Fed has announced an extension of the swap lines until October 2009.
Government financial policy actions
Governments across the world have continued to unveil new measures and modify existing measures aimed at stabilising their banking sectors. Both injections of equity, usually in the form of preferred shares, and usage of government guarantees on newly issued bank debt have been extensive, with global issuance of guaranteed bank debt over US$300 billion since October (see below). Nonetheless, bank share prices, particularly in the United States and the United Kingdom, have come under significant pressure on concerns about future losses. Rating agencies have recently downgraded the ratings and outlooks of a number of major US and European banks. While acknowledging the benefits of government support for these systemically important banks, the rating agencies believe that the increased regulatory pressure for them to deleverage and restrict certain business activities will lead to structurally lower profitability.
In the United States, the full US$700 billion available under the TARP has now been released by the US Congress, with around half of that amount already disbursed (Table 4). To date, the US Treasury has focused on using these funds to recapitalise the US financial system. In particular, it has invested US$195 billion in the form of senior preferred shares in 361 institutions, including nine of the largest US banks. The US Treasury has also established other programs to support institutions whose failure would likely cause severe disruptions to the financial system. Under one of these new programs, Citibank and Bank of America (BoA) have received a further US$20 billion of capital each. The US authorities have also provided each of these banks with insurance against unusually large losses on pools of their (on balance sheet) assets: each bank bears the initial losses on the insured assets – the first US$29 billion of losses in the case of Citibank and the first US$10 billion in the case of BoA – and any further losses will be shared between the bank and the Government, with the Government bearing most of the burden. In the case of Citigroup, US$5 billion has been allocated for this contingency. In addition, TARP funds have been committed to: facilitate a capital restructure of AIG; provide credit protection to a Fed special purpose vehicle under the TALF; and provide support for the US auto companies, including their financing arms.
In mid January, the UK Government announced a second package to assist the financial sector following the initial measures introduced in October 2008. Measures proposed in the package include: an extension to the end of 2009 of the credit guarantee under which financial institutions can issue debt; the guarantee of certain AAA-rated ABS; Government insurance against losses on certain assets under specified arrangements; BoE purchases of up to £50 billion in certain assets on behalf of the Treasury; and a restructure of Northern Rock’s business plan such that it is no longer required to reduce its lending. The UK Government also announced that it will convert its preference shares in Royal Bank of Scotland to common shares, thereby increasing the bank’s core tier 1 capital and taking the Government’s stake to around 70 per cent.
Ireland, which was the first country to provide a guarantee on bank debt, has more recently announced a €10 billion package to recapitalise the country’s banks. So far, the Irish Government has said that it will invest a total of €4 billion in new preference shares in two of the country’s banks and has nationalised a third. The recapitalised banks have agreed to a credit package, which includes providing additional capacity for lending to small and medium businesses and first-home buyers. In continental Europe, German and French banks, among others, have continued to receive capital injections. Korea has also announced plans to recapitalise its banking system.
Government-guaranteed bond issuance
There has been significant issuance of government-guaranteed bonds by financial institutions since the last Statement. The monthly value of guaranteed bond issuance is currently substantially higher than the average monthly bond issuance by banks in the pre-crisis period of around US$50 billion. Spreads on US dollar-denominated issuance fell sharply in December, and have narrowed again in recent weeks (Graph 19). However, yields remain well above sovereign yields, notwithstanding the fact that these issuances are fully backed by governments.
In the United States, total issuance under the FDIC’s Temporary Liquidity Guarantee Program currently stands at the equivalent of over US$130 billion, with US dollar-denominated issues trading at spreads of between 60 and 100 basis points to Treasuries with equivalent maturity (Table 5). European financial institutions have also raised debt under various government guarantee programs. Issuance under the British and French programs is currently over US$30 billion in each case. The majority of euro issues are trading at spreads of between 70 and 125 basis points to equivalent Bunds, while sterling issues are trading at spreads of between 80 and 100 basis points to equivalent Gilts.
Sovereign debt markets
Yields on government bonds in the major developed economies have declined since the previous Statement, reflecting the deteriorating outlook for economic growth and the abatement of inflationary pressures. The aggressive reduction in policy rates, in conjunction with expectations that these rates will remain low for an extended period of time, has led to steep falls in the yields on short-term government bonds in the major developed economies. Yields on longer-term government bonds have also fallen: yields on 10-year US government bonds fell by as much as 160 basis points to their lowest level since 1950 (Graph 20); and yields on 10-year German government bonds fell by as much as 80 basis points to their lowest level since 1923. In recent weeks, yields on 10-year bonds have retraced some of these falls.
Spreads between the yields on sovereign debt of other countries in the European Monetary Union (EMU) and German sovereign debt widened significantly to reach their highest levels since the formation of the Union in many cases (Graph 21). The widening reflects increasing investor concern about the impact of the global economic slowdown and government debt guarantees on the budget deficits and levels of public debt in euro area countries. Citing these issues, the rating agency Standard & Poor’s downgraded the sovereign credit ratings of Greece, Spain and Portugal, and placed Ireland’s sovereign debt rating on negative watch in January.
Spreads on US dollar-denominated sovereign debt of emerging economies in Asia, Europe and Latin America increased sharply in the second half of 2008 as the economic slowdown, which until then had mainly affected developed economies, extended to emerging markets and risk appetite retracted (Graph 22). Spreads have narrowed from their November peaks as appetite for riskier assets has returned to some extent and several emerging markets have issued US dollar-denominated debt recently. However, spreads remain elevated relative to the levels observed over the preceding two years.
Despite the deterioration in the global economic outlook since the last Statement, spreads across most credit markets have narrowed somewhat, indicating that policy actions designed to improve conditions in these markets are having some effect. In interbank markets, spreads between LIBOR and the expected cash rate have declined significantly since the time of the last Statement, although they remain well above pre-crisis levels (Graph 23). A noticeable increase in lending volumes at maturities out to six months is a further sign of improvement in conditions in these markets.
In response to severe pressures in the US commercial paper market, the Fed introduced a number of initiatives that, in conjunction with the overall improvement in money markets as noted, have helped to reverse part of the deterioration in conditions. Issuance of commercial paper with longer maturities has increased and spreads have declined to below the levels that have prevailed since the onset of the financial crisis (Graph 24).
In the United States, and elsewhere, longer-term corporate bond yields have also fallen from their peaks in late November, led by the falls in government bond yields (Graph 25). The spreads between these yields and yields on US Treasuries have also fallen from their multi-year highs of November. However, global issuance of unguaranteed debt remains weak. There was little private issuance of MBS in the United States in the second half of 2008, and most issuance of MBS in the United Kingdom and Europe continues to be in the form of self-securitisations by institutions looking to access central bank funding.
From October to early December last year, volatility in equity markets was higher than at any time since at least the 1980s (see Box A); on 1 December 2008 the S&P 500 fell by 9 per cent, the second largest daily fall since the 1987 stock market crash, in response to the release of poor economic data in the United States. Since the last Statement, the Nikkei index has fallen to its lowest level since 1982; the S&P 500 to its lowest level since 1997; and the Euro STOXX to its lowest level since 2003 (Graph 26, Table 6). More recently, equity markets have broadly moved sideways.
Share prices of financial companies have fallen by more than those in other sectors, in part because various government recapitalisations have diluted the equity of existing shareholders and financial institutions in the United States, euro area and United Kingdom have continued to report large losses. The share prices of many banks in these economies are between 80 per cent and 90 per cent lower than they were prior to the crisis. The large appreciation of the Japanese yen has contributed to the losses on Japanese equities as a number of large exporters with substantial foreign revenue sources revised their earnings forecasts sharply lower.
In the United States, the declines in equity prices have outpaced the falls in earnings, with the result that price/earnings (P/E) ratios have fallen to levels around their long-term averages (Graph 27). The same is true for many other developed economies.
The performance of equities in emerging markets has been mixed since the previous Statement but share prices have, in general, fallen as the economic slowdown in developed countries has reduced exports from emerging markets and commodity prices have declined. Equities in emerging Europe have experienced the largest losses because of concerns about the sustainability of large current account deficits in a number of economies in that region and lost export earnings due to sharply lower commodity prices. On the other hand, Latin American equities have rebounded from their late November lows as central banks in the region have begun to reduce policy rates for the first time since the onset of the financial crisis, leaving equity markets largely unchanged over the past three months.
After peaking in late 2008, volatility in foreign exchange markets has subsided, but remains at high levels. In this environment of high volatility, the yen and Swiss franc have appreciated significantly against most other currencies, including the US dollar, partly as a result of further unwinding of carry trade positions and low risk appetite (Table 7). The US dollar depreciated in December 2008, possibly reflecting an easing in flows associated with the repatriation of offshore investments that had led to its appreciation through much of the second half of 2008. Since the beginning of 2009, however, the US dollar has appreciated, and is little changed in trade-weighted terms since the last Statement (Graph 28). The US dollar is now 19 per cent above the lows reached in March 2008. In contrast, the British pound depreciated to its lowest levels against the US dollar since 1985 and to its lowest level against the euro since the formation of the EMU, as the financial and economic outlook for the United Kingdom deteriorated more rapidly (Graph 29).
Asian currencies were mixed against the US dollar (Graph 30). The Indonesian rupiah and Korean won fell to their lowest levels since 1998 in November. They rebounded in December and early January, as risk appetite briefly improved, but have subsequently depreciated. Other Asian currencies are little changed against the US dollar since the last Statement. The Chinese renminbi has been unchanged against the US dollar over the past six months but has experienced a noticeable appreciation in both effective terms and against other Asian currencies (Graph 31). Many Asian central banks took the opportunity of more stable conditions in their currency markets in December to rebuild their reserves, which had been run down by around US$200 billion across the region in the previous six months to alleviate downward pressure on their exchange rates.
The Russian ruble, which is managed against a basket of euros and US dollars, has been allowed to depreciate by more than 25 per cent since the previous Statement. The sharp fall in commodity prices, particularly oil, and the earlier geopolitical tensions in the Caucasus have led to capital outflows and a large fall in Russia’s foreign reserves. The Russian central bank has said it will allow a further depreciation of the ruble and the market for non-deliverable forward contracts is currently pricing in a depreciation in excess of 15 per cent over the coming year. A number of Eastern European currencies, especially the Hungarian forint and Ukrainian hryvnia, have depreciated against the US dollar on persistent concerns about the ability of these countries to maintain large current account deficits and to finance external debt. Several emerging Eastern European countries, including Hungary and Ukraine, have sought IMF support to stabilise their financial markets. Latin American currencies also depreciated in line with the falls in commodity prices.
Following the sharp depreciation in October 2008, the Australian dollar has traded in a relatively wide range. In net terms, the Australian dollar has depreciated by 4 per cent against the US dollar and in trade-weighted terms since the last Statement to be 10 per cent below its long-run average in trade-weighted terms (Graph 32, Table 8). Through December and early January, the Australian dollar appreciated steadily on the back of improving global risk appetite to reach 3-month highs against the major currencies. However, these gains have subsequently been retraced, as the Australian dollar remains sensitive to swings in risk appetite of global investors.
In line with trends in other financial markets, volatility in the Australian dollar exchange rate has declined from the unprecedented levels observed in October 2008. Nonetheless, volatility remains high by historical standards, with the intraday range in the Australian dollar in January still above the average seen since the onset of financial market turbulence in August 2007 (Graph 33). Some of this volatility is related to the high correlation in recent months between movements in the Australian dollar and prices of other assets, notably the S&P 500. This has been most evident during the lead-up to the close of the New York Stock Exchange, when US equity markets have been particularly sensitive to shifts in investor sentiment.
With a return to relative stability in the foreign exchange market, there has been little need for the Bank to support liquidity in the market compared with the previous Statement period. Consequently foreign reserve assets have remained relatively stable. The US dollar swap facility with the Federal Reserve (see above) has had no impact on reserve assets: the US dollar funds obtained by the Bank under the facility have been immediately lent to domestic financial institutions in exchange for Australian dollar securities.
For the most part, domestic institutions have held these funds in short-term foreign instruments rather than using them to fund domestic assets. This is reflected in balance of payments data for the September quarter, which indicate that there were some changes to the typical composition of the financial account of the balance of payments. The absence of offshore funding prior to the introduction of the Government guarantee and a large increase in offshore assets of financial institutions saw a net outflow of bank and money market capital in the quarter. This was offset by an unusually large repatriation by Australian investors of their foreign portfolio debt investments. Funds obtained via the Bank’s US dollar swap facility with the Fed appear to have mostly financed large purchases of short-term foreign assets by domestic financial institutions, indicating these funds were on-lent to offshore banks and had little net effect on the financial account in the September quarter.
- For more on recent developments in the Fed balance sheet and policy instruments, see ‘Box A: Developments in the US Federal Reserve’s Instruments’, Statement on Monetary Policy, Reserve Bank of Australia, November 2008, pp 21–22.
- For more on the US dollar swap arrangements between central banks, see ‘Box B: US Dollar Swap Arrangements between Central Banks’, Statement on Monetary Policy, Reserve Bank of Australia, November 2008, pp 23–25.