As the year is coming to a close, the financial economy in large parts of the world is characterised by high levels of uncertainty and central banks navigating through widely unknown territory. In this article, I want to take a brief look at the state of affairs in a few different economic areas and analyse potential implications for monetary policy decisions. For this purpose, a proxy for the financial cycle as developed by Drehmann et al. (2012) from the Bank for International Settlements (BIS) is presented as a visualisation tool. This concept captures cyclical fluctuations in both private credit and house prices. A high point represents above-trend volume of credit to the private non-financial sector and elevated asset prices. A low point on the other hand indicates a contracted credit and housing market (You can find a very brief description how the financial cycle is derived at the end of this article). Additionally, I consider some other important developments throughout the global financial economy.
After a long contraction phase in the aftermath of the financial crisis, the US financial economy has started to expand again in recent years, indicated also by a rising financial cycle. To be sure, the estimated credit-to-GDP gap, the difference between the credit-to-GDP ratio and its long-term trend, is still roughly -10 percentage points. Note however, that this assumed trend is most likely upward sloping despite the fact that there is no obvious reason why credit should consistently outgrow the economy. Moreover, domestic credits have increased by five percent year-on-year (yoy) in recent quarters (BIS, 2016). As interest rates remain at low levels, this has not yet translated into a significant increase of the debt-service-income ratio (the share of income used to service debt) away from its all-time low, a measure frequently used as an early warning indicator for financial unrest. House prices have been on the rise ever since 2012 as well, climbing to new highs in nominal terms and back to their levels of 2004 in real terms. There is a strong link between the housing market and credit. Elevated house prices mean high levels of available collateral for new credit and a credit expansion fuels the demand for housing and hence drives up prices. Additionally, US stock markets have been on a long-term upward trend since 2009 and have set new records following the recent presidential election. On December 14, the Federal Reserve (Fed) decided to raise its target rate to 0.625 percent, citing a tightening labour market and somewhat increased inflation expectations. However, it only expects a slow return back to higher interest rates and target inflation. While the Fed has stopped its asset purchase programmes back in October 2014, its balance sheet remains inflated compared to pre-crisis levels which is due to the fact that the central bank reinvests principal payments from its holdings and rolls over maturing Treasury securities. It goes without saying that the election of Trump has introduced a great deal of uncertainty into expectations about the US economy. It should be interesting to see whether tax cuts and infrastructure spending expansions pledged by the President-elect will lead to a faster monetary tightening by the Fed. Focusing on the financial cycle, further rate hikes seem warranted in order to avoid a recurring overheating of the financial economy.
In the Euro Area, the estimated financial cycle is at its trough. While real house prices have slowly started to rise again in very recent years, the volume of credit to the private non-financial sector has been stagnant since the onset of the still not resolved European Debt Crisis. With the inflation rate remaining well below its 2-percent target, the European Central Bank (ECB) has further decreased its key interest rate to 0.0 percent in March 2016. But unlike other central banks, the ECB sets one interest rate for multiple economic areas that are not connected by a strong fiscal union (Some might argue that the purchase of sovereign debt by the ECB makes the Euro area an implicit fiscal union – this however is an issue for a whole new discussion). The difficulty that this might introduce becomes evident when comparing the relatively modest and rising financial cycle of Germany and that of Italy which is more volatile and about to reach its trough (Note that the financial cycle measure is somewhat imprecise at the current edge – Italy might see more contraction in the financial economy before it starts to rebound).
In Germany, credit had been contracting for many years since the mid-2000s and seems to be picking up some upward momentum in recent years. In Italy, however, the credit-to-GDP ratio has just started to decrease and might continue to do so, partly due to a high stock of non-performing loans and low equity levels on the balance sheets of Italian banks. And while real house prices have been falling ever since the financial crisis in Italy, they are growing strongly in Germany ever since 2010. Additionally, while below its 2-percent target in both countries, inflation has recently been lower in Italy. Moreover, both the real economy and the stock market have performed relatively better in the recent past in Germany. All this implies that interest rates should maybe be slowly increased to avoid an overheating in the German financial economy while the ECB might at the same time be well advised to keep its rate low in order to fuel the Italian real and financial economy. All issues in the Euro Area are aggravated by very high levels of political uncertainty and ongoing sovereign debt crises. And any existing structural problems seem unlikely to be resolved in 2017, when many Euro countries will be preoccupied with domestic politics. In this environment, the ECB has decided to leave its interest rate at zero and to continue its asset purchase programme at the current monthly pace of €80 billion until the end of March 2017 and subsequently to continue at a monthly pace of €60 billion until the end of December 2017, leaving itself the option to further increase this programme again in both size and duration in the future. At this point it appears unclear how a strategy to solve the underlying problems of the Euro crisis might look like which could spell further trouble for the financial economy in the monetary union in the future.
In the United Kingdom, the financial cycle has just started to increase again after its post-crisis contraction. Real house prices have been climbing since 2013 while credit to the private sector is still slowly decreasing. Stock markets have been rising to new highs in the wake of Brexit (especially stocks of companies that get the vast majority of their revenue from outside the UK), a development that is however offset to a substantial extent by the falling pound. In response to the financial crisis, the Bank of England (BoE) had been keeping its bank rate low at 0.5 percent since March 2009 and has been running an extensive asset purchase programme to acquire government bonds. This has kept interest rates on government bonds low and during the same time, public debt has been substantially increasing (from about 82 percent of GDP in 2010 to roughly 108 percent in 2016; BIS, 2016). In the aftermath of the Brexit referendum, the BoE further cut its rate to 0.25 percent and started to additionally purchase corporate bonds in September. After it has been surprised by positive economic numbers in recent months, the BoE has made a U-turn and has scrapped its plans to lower rates even further and to expand quantitative easing programmes. Accordingly, on December 15 the BoE held its rate constant and decided to continue its asset purchase programmes at an unchanged pace. As a consequence of the Brexit referendum, the weak pound already puts upward pressure on UK consumer prices. Should this be combined with a surprisingly strong real economy in the near future, a return back to more orthodox interest rates can be anticipated. Although not necessarily indicated by a still low financial cycle, this might help to reduce the risk of ballooning public debt. However, high political uncertainty seems to be a returning theme of this article. And it is definitely fitting for the United Kingdom as it is bound to renegotiate its entire array of trade deals in the next few years. This uncertainty also dominates the BoE’s monetary policy outlook at the moment and future policy decisions could go either way. Thus, the impact Brexit will have on the British financial economy with its strong international ties and the growing amount of public debt remains to be seen.
China is the only one of the world’s largest economic powers where the financial economy is arguably at or close to the end of a boom phase. The credit-to-GDP ratio has doubled during the last 15 years and real house prices, while volatile, have also been on the rise. Only Chinese stocks have been trading mostly sideways ever since a burst in 2015. In the past, the Chinese government has used new regulation to slow down an overheating of the credit and housing markets (e.g. purchase restrictions and property taxes; see Du & Zhang, 2015). In recent years, however, with economic growth slowing, it seems that it has sometimes become more tolerant of rising prices although there were a couple of new restrictions introduced in various cities this autumn. Additionally, the People’s Bank of China has been cutting interest rates ever since 2012, further accelerating an expansion of the financial economy even though its chief economist Ma Jun has warned of a housing bubble in September 2016. Now the central bank might be caught in a similar trap to the one the Fed was in before the financial crisis in the US. If interest rates stay low, the credit volume and house prices are bound to further drastically increase. If they rise, private debt becomes more expensive and debtors start to default which in turn causes the house price bubble to burst. The latter is a large part of what triggered the financial crisis in the US in 2007. It is all the more troubling that the debt service ratio of the private non-financial sector has already substantially increased in recent years in China (from roughly 15 percent in 2010 to about 20 percent in 2016; BIS, 2016). This is arguably one of the key developments in the global financial economy to watch out for in the near future.
From a European point of view, it is always worthwhile to look at the case of Japan as its society has been facing the challenges of demographic transformation and long-term stagnation earlier than other developing countries have. Japanese inflation has been low and often even below zero ever since the financial crisis in the 1990s. In 2013, the Bank of Japan explicitly raised its inflation target to 2 percent and subsequently ventured into the most rapid balance sheet expansion of all large central banks to meet this target and now stands at a negative interest rate (-0.1 percent). In September 2016, it issued a commitment to continue its asset purchase program until inflation returns to a stable level exceeding 2 percent. Even in this environment, both private credit volume and house prices have been stagnant and at times even sinking, as well as consumer prices, while stock prices have merely returned to their levels of the 90s. It seems that only the public debt is steadily increasing which is now worth roughly 227 percent of Japan’s annual output, by far the highest value in the world (BIS, 2016), a situation that is only sustainable because most of Japan’s debt is held by its citizens and it has power over its own currency (a luxury that southern Euro countries do not enjoy). On one hand, given the stagnating asset prices and private credit volume it seems unlikely that the aggressive monetary policy of the Bank of Japan will cause a bubble in the financial market anytime soon (Note that the estimated financial cycle is only on the rise due to the fact that the long-term financial contraction has stopped). On the other hand, it is also questionable whether it will be able to accomplish the targeted inflation rate without having to add controversial measures like a devaluation of the yen (Cecchetti & Schoenholtz, 2016) or helicopter money. One should probably be most concerned with possible instabilities that the ballooning sovereign debt might cause in the future, fuelled by the central bank’s purchase program and its explicit intention to keep government bond yields at zero percent. This might become especially troubling once Japan loses its robust domestic saving or its appeal as a safe haven (see Horiaka et al., 2014).
Some other noteworthy developments
Unlike in most other countries of the Western world, in Canada real house prices have not experienced a drop after the financial crisis and have instead seen a steady increase ever since the early 2000s. The same can be said about credit, leading to an elevated financial cycle measure. In December, the Bank of Canada decided to leave its interest rate at 0.5 percent amid high uncertainty and below-expectation inflation. This likely means that growing concerns about a bubble in the Canadian financial economy, especially the housing market, will not go away anytime soon.
In Switzerland, the financial cycle indicates a peak (again, note that the financial cycle measure can be imprecise at the current edge). Real house prices have been rising for decades, and so has credit. The target rate of the Swiss National Bank (SNB) is currently -0.75 percent, the lowest in the world. It is the SNB’s intent to depreciate the franc and consequently to discourage investments in Switzerland. So far this does not appear to be working however as the inflation rate is below zero. As interest rates remain at record lows, banks are likely to issue increasingly risky debt in the future, aggravating existing bubble concerns.
Lastly, in Sweden real house prices have been surging for the last two decades (increasing by roughly 250 percent during that period). The credit-to-GDP ratio, on the other hand, has been somewhat stagnant since the financial crisis but remains on a comparatively high level. The central bank’s rate is the second lowest in the world at -0.5 percent. Swedish authorities have recognised elevated risk in the housing market under these conditions and see the need for a tighter regulation (Riksbank, 2016).
It can be concluded that in many countries the money supply has recently been multiplied by central-bank asset purchase programmes amid interest rates close to zero. While this did not yet lead to a substantial increase in consumer prices, it has in some cases already led to rising asset prices and elevated levels of public and private debt. Those countries that have been hit most severely during the financial and the ensuing Euro crisis still exhibit low points in their financial cycles, despite long-lasting record lows in their interest rates. Other countries that have been mostly spared from turmoil now face situations that are somewhat reminiscent of the years before the financial crisis. It will be intriguing to see how the global financial economy is going to develop during the upcoming year, fraught with political uncertainty and central banks around the world with all but empty tool kits and often times not taking the financial cycle into consideration.
What is the financial cycle? The one that is presented in this article was introduced by Drehmann et al. (2012) in a BIS Working Paper and is derived by applying a Christiano and Fitzgerald (2003) band pass filter to series of credit volume, credit-to-GDP ratio and house prices, all in yoy growth rates. The resulting financial cycle is the average of the thus estimated long-term (8 to 32 years) fluctuations in these three variables. It should mostly be understood as a tool to understand medium-to-long-term developments in the financial economy and to visualise them and one should be aware of its approximate and imprecise nature (especially at the current edge). For a technical understanding, the interested reader is referred to the above cited papers.
The derivation of the financial cycles is based on a term paper that I have recently written with my friends Philipp Hochmuth, Max Wallin and Ben Wells. I am thankful to Dr. Thomas Strobel who brought this intriguing topic to my attention during my internship at UniCredit Global Economics Research.
This article is also published in this year’s annual brochure of the Börsenforum Augsburg, a student initiative providing information about and an insight into the financial economy in close cooperation with international companies.
Bank for International Settlements (BIS). (2016). BIS Statistical Bulletin, September 2016.
Cecchetti, S., & Schoenholtz, K. (2016). The Bank of Japan at the policy frontier. VoxEU.org, 7 December 2016.
Christiano, L. J., & Fitzgerald, T. J. (2003). The band pass filter. International Economic Review, 44(2), 435-465.
Drehmann, M., Borio, C. E., & Tsatsaronis, K. (2012). Characterising the financial cycle: don’t lose sight of the medium term! BIS Working Papers No 380.
Du, Z., & Zhang, L. (2015). Home-purchase restriction, property tax and housing price in China: A counterfactual analysis. Journal of Econometrics, 188(2), 558-568.
Horioka, C. Y., Nomoto, T., & Terada-Hagiwara, A. (2014). Why hasn’t Japan’s massive government debt wreaked havoc (yet)?. VoxEU.org, 21 January 2014.
Riksbank, S. (2016). Financial stability report 2016:1. Semi-Annual publication.
written by Jonas