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The words uncertainty and volatility have a  strong presence and usually we had central banks stabilizing things at these times. But are they out of ammunition? The team at Bank of America Merrill Lynch explains:

Here is their view, courtesy of eFXnews:

…Central banks still can move the markets, but do they have enough ammunition to deal with the next financial crisis or economic downturn?

At the outset, we think the BoJ and ECB will have a very hard time, repeating the big currency moves of the last few years.  It is not normal for small shifts in policy””such as more aggressive QE””to cause double digit currency depreciations.

In our view, the big move in the Yen and Euro in the last few years is mainly a one-off response to regime shifts at the three main central banks: (1) the shift from Trichet to Draghi at the ECB,  (2)  the BoJ’s shift from reluctant QE to aggressive QE in April 2013 and  (3)  the Fed’s move from “risk management super-easy policy” to “data dependent tightening,” starting in summer 2013. Market recognition of this regime shift explains both the dramatic appreciation of the dollar through last March and its stability since then.

Looking at the big three, in our view, the Fed is in by far the best position to deal with adverse shocks.  As we noted in a recent piece, if the economy or markets weaken sharply we would expect the Fed to cut rates to zero, signal a long on hold, then move to  manipulating the yield curve through an “operation twist” and/or QE4 and finally, as a last resort, they would move into the uncertain world of negative rates. The Fed also has plenty of liquidity tools to deal with a financial crisis, and its jawboning powers are intact.

The ECB has less room to manoeuvre since it is already more than half way down the path the Fed would take. Gilles Moec and team believe QE can still be tweaked to get more loosening toward the long end of the curve. Targeted Longer Term Refinancing Operations (TLTRO) could be made more attractive to shore up banks’ financial position. The ECB also has effective jawboning ability given the strong reputation of President Draghi. If all else fails, they could get into direct buying of loans from banks. This is one option the Fed does not have.

In our view, the BoJ has the least ammunition.  They have already gone down the path of taking credit risk onto their balance sheet, although there is much more room to expand in that direction. Rates are already negative, but could be cut much further. Indeed, by applying negative rates to only new reserves central banks can go deeper negative without major damage to bank profitability. The BoJ probably has the weakest jawboning ability. While Governor Kuroda has restored a large part of the central bank’s credibility, a legacy of many years of deflation and ineffective policy still haunts the Bank. One rough gauge of policy ammunition is the current level of 10-year bond yields. After all, the goal of many of the unconventional tools is to push down the whole yield curve, causing portfolio rebalancing into other markets.

Will it work? Whether policy makers succeed or fail in the coming months depends not only on the amount of ammunition they have, but on the size of the shock they face.

Historically, pure market panics with no major fundamental drivers can be handled with aggressive liquidity injections and jawboning, but with relatively little macro policy easing. For example, the Fed was able to stabilize the markets and protect the economy after the 1987 stock market crash and the 1998 fixed income freeze, with just 80bp and 75bp respectively of policy easing. On the other hand, none of the central banks have the kind of ammunition that usually comes into play during a recession. For example, in the last three recessions the peak to trough drop in the Fed funds rate was 675bp, 550bp and 500bp, respectively.

The good news here  is that the uneven recovery in the big three economies has not produced overexpansion of cyclically sensitive sectors that normally happens late in the recovery.  This suggests the next recession could be mild.

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