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2018-01-31Macro `n Cheese

What monetary condition are you in?

What good are Monetary Conditions Indices (MCIs), we recently asked Roger. His answer was, for once, quite compelling: Well, even if we hardly have any interest rate left, we still want to understand how monetary policy works. That’s why the use of MCIs are even more important these days.

At this time of year, it seems that everywhere you look, everybody is on a diet or in a training program. Or, at the very least, using an app that helps them achieve these goals. Since I know most of you are already using the Macrobond App to become productive and successful, I thought it would make some sense to measure what monetary condition your economy is in. Partly to see if it rhymes with recent developments and partly, of course, if it allows us to say something about the immediate future.

To do so, I have chosen seventeen variables that should reflect not only interest rates, but also exchange rates, money growth and the unconventional measures that have been executed since the global financial crisis. Selecting the variables, I have taken a cue from Wu & Xia’s (2014) paper. The fact is, that the calculated MCIs could quite easily be used for creating and comparing “shadow rates”1. In comparison with some other studies on monetary and financial conditions, I have not ventured into adding sentiment, asset prices and credit spreads (at least not directly)2, which is not to say that such an extension would not be interesting, but rather that I prefer variables that are closer to policy actions than other circumstances (and spirits).

The method used is a Principal Components Analysis which creates a smaller number of “artificial variables” that can be used to explain our data. These variables – components – are ranked in accordance with how much of the total variance they explain, with the one explaining the most being the first principal component (PC1), and so on. In deciding how many components to use when constructing the MCI-index I have arbitrarily set a cut off at 80% cumulative explanation, which in this case implies a use of the first four principal components for all countries and regions involved. The MCI is then constructed by summing the individual principal components weighted by the share of total variance explained by each component. The result is then divided by the share of total variance explained to ensure comparability between countries. (A link to the calculation of the weights used, in Excel, is provided here.)

And the winner is...

Now that we have the technical issues out of the way, let’s have a look at how the Euro Area is performing given the recent strength of the EUR and the disparities within the Euro Area. To do this, I have chosen to construct an MCI for the Euro Area aggregate as well as for Germany and Italy, two countries who could be expected to have responded differently to ECB-policies, at least over the past few years.

1 If inverted and normalized to the mean and standard deviation of the policy rate in the respective country.
2 Such variables are, nonetheless, easy to add to the models.

Macrobond Document Macrobond Document
Chart 1a & b: Super Mario has been coming on strong...

In the loadings matrix3, the first component (PC1) is strongly related to interest rate variables and can thus be said to represent conventional monetary policy measures. The second component (PC2) mainly picks up on the variables related to the ECB’s balance sheet (and, with a reversed sign, also on the currency). As we go deeper into the principal components, it gets harder to completely dissect what the components pick up on, but the third component (PC3) is highly correlated to exchange rate variables while the fourth component (PC4) seems to draw weight from the monetary aggregates.

When playing around with the model, I noticed that the somewhat curious reversed signs of currency variables and what we have interpreted as the “UMP”-component (PC2) seems to be a case of “buy the rumor sell the fact” kind of behavior. Or, perhaps, the ECB’s “lean against the wind”-policies if you prefer. Furthermore, when adding asset prices into the mix, these seem to have a very strong correlation with UMP-measures, underlining the oft stated “portfolio balance channel” of the transmission mechanism of UMP-measures.

OK, it seems the ECB has indeed been working its magic, but is this true for the entire Euro Area? – Well, looking at two “extremes”, Germany and Italy, is quite enlightening in that respect.

3 I.e., the ‘matrix’ node in the tree structure when you open the MB-file. I will not comment as thoroughly on all the PCA analyses, but the following should give an idea on how to interpret the output of the PCA analysis in Macrobond. If the Eigenvectors were supplied as data in MB, we could fully automatize all our calculations in this analysis. So, yes, keep those support-tickets coming!

Macrobond Document Macrobond Document
Chart 2a & b:…But it’s mainly been Germany who has been reaping the benefits

While both countries have enjoyed stimulative monetary policy, it is obvious that Germany has, on average, reveled in a considerably more expansionary monetary policy than Italy. And when looking at the eigenvectors/loadings matrix (in the MB-document), we see that Germany has had a much more positive effect from monetary policy on almost all accounts, but in particular those that are related to the effects on monetary aggregates and the currency, catering to a view that Italy is suffering from structural problems. Again, if you are more interested in exploring the different effects of ECB monetary policy within the Euro Area, other variables could probably be added to the analysis as well4.

Another take-away, especially given my recent piece on the political risks in the Euro Area, is that Italy’s monetary conditions have tightened considerably in the recent past. Given the anything but EU/EUR-positive sentiment among Italian politicians, and an upcoming election, a relative weakening of the business cycle will not be beneficial for the essential structural reforms.

When and where did whom do what?

When I started to think about this week’s post I was mainly interested in seeing whether and how the MCIs agree with a commonsensical view of the cyclical positions of major currency areas. Indeed, I hoped to see some pattern that would help us peek into the immediate future, as this upswing is already one of the longest we have experienced on a global scale.

4 An ECB-paper from 2013 explores this is in a similar analysis. It is easily replicated using this framework and MB.

Macrobond Document Macrobond Document
Macrobond Document Macrobond Document
Note:The Euro Area calculations are slightly altered compared to above.
Chart 3:Will US be the first victim of excessive monetary policy tightening?

When looking at the various MCIs they do seem to be in line with what one could expect. One thing that definitely stands out is the extreme loosening and tightening of financial conditions in and around 2012, when Draghi held his infamous “whatever it takes”-speech. This seems to be driven, first, by the introduction of various supportive ECB-measures, e.g., the Securities Market Programme (SMP), and a significant depreciation, and then, when tightening, by the roll-off of previous ECB UMP-measures (SMP, CBPP, LTRO etc.). Furthermore, this is also when the ECB hit the lower bound and the transmission mechanism became heavily impaired (due to perceived risks in the banking sector), providing additional, endogenous, tightening.

The latter observation, an endogenous tightening, does reflect on the apparent structural problems that become pertinent in all major economies (with, perhaps, the exception of Japan) at the time of the crisis, and fits nicely with the discussion on a lower natural rate of interest and the “jump” discernable in most of our MCIs (around the time of the crisis).

For Japan it is clear that, if nothing else, the first arrow of Abenomics hit the mark with a massive improvement in monetary conditions. When looking at the various components and variables underlying our MCI for Japan, we find that is seems the currency effect has been very strong, which raises some concerns pondering the recent strengthening of the JPY. These concerns are also very much present when looking at the European situation, where the currency along with the asset purchase programs, have been instrumental in making monetary conditions expansionary over the past few years. As the EUR is now strengthening and many ECB board members speak openly about an imminent tapering, there are probably good reasons to suspect that some type of slowdown lie ahead.

Nonetheless, in my opinion, the perhaps most interesting aspect of the above run-through is the US MCI, which is rapidly approaching neutral territory. With further tightening in the offing, both via interest rate hikes and an accelerated tapering, I would not be surprised to see a more pronounced deceleration of US growth rates. In many ways, this is possibly already accounted for, judging from the publicly available forecasts of the US economy. I wonder, however, do financial markets really agree?


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We don’t usually have views and opinions about economic and financial states of affairs, (not ones that we express publicly as a company, anyway). We do believe, however, that people can and do appreciate a variety of perspectives. What you’ve just read is the perspective of our resident chief economist. While we think he’s very smart, Macrobond Financial does not expressly endorse the views he presents here. And, as the old adage goes, you shouldn’t believe everything you read (not without finding the data, performing a few analyses and presenting it in a nice chart). We want to make it clear that we are not offering this information as investment advice. That being said, if you have the application you can easily check everything that’s mentioned here, and decide for yourself. If you don’t have the application, now you have a great reason to get it.