Central Bank Insight – Q3 2017
It is clear that the global Central Banks are shifting their thoughts to scaling back the unconventional policy support that has been in place in recent years. In terms of the current debate about Central Bank policy, the Federal Reserve appears to be the one where the most disagreement is happening regarding the ‘next step’. Recent days have seen the official ten-year anniversary of the credit crisis and we are all aware we are still very much living with the Quantitative Easing policies put in place in the aftermath. Interest rates remain at historically low levels and the major surprise for most analysts has been the lack of pick up in global inflationary pressures. Janet Yellen completes her term next February and so we will soon hear about potential candidates, President Trump will no doubt have a strong opinion!
In a recent set of minutes, "some participants" who counseled patience expressed "concern about the recent decline in inflation" and said the Federal Reserve "could afford to be patient under current circumstances." They "argued against additional adjustments" until the central bank was sure, that inflation was on track. Inflation has continued to lag the Federal Reserve’s target of 2%, last month having risen by 0.1% to take the year-on-year consumer price index to 1.6%, prompting some to question whether the central bank should be raising rates. Having not really come close to the 2% target since 2012 maybe the Federal Reserve needs to rework its basic inflation model so they can be sure they are setting rates at the right level and be confident they are also giving the right sort of forward guidance.
On the other side, more hawkish members "worried about risks arising from a labour market that had already reached full employment and was projected to tighten further." With unemployment at such low levels, there was concern that any delay in tightening could create long-term imbalances. However, while a September rate hike appears less likely in light of the afore mentioned minutes, the market is still expecting the Federal Reserve to begin shrinking its $4.5 trillion (£3.5 trillion) balance sheet next month, through reducing reinvestment of maturing bonds with an initial cap of $10bn a month. t is possible that with a lower equilibrium level of interest rates than in the past, that even a small amount of monetary tightening could have an amplified effect.
In Europe, the ECB is faced with more favourable economic conditions than many people foresaw and is starting to consider trimming the level of support. The inflation data also continues to be surprisingly muted. The one factor that Mario Draghi and his colleagues will not be able to ignore is the recent strength of the Euro. So far, this year the currency has risen nearly 15% but this makes imports cheaper, ultimately making it harder for the ECB to hit its inflation target. This could make normalisation harder to achieve, although Draghi insists that the loose monetary policy is the very reason for the current positive outlook. Eurozone growth has been stronger than expected so far this year, so much so that the ECB now expects growth this year to be 2.2% - the strongest in a decade.
At the latest meeting, the ECB’s governing council announced they will “probably” be ready to make a decision in October on whether to taper its €60bn a month bond-buying programme. Investors assumed this meant the programme will be scaled back to purchases of about €40bn a month from January 2018.
Of course, the issue with exchange rates is that where one is strengthening, others are weakening and in the UK, the MPC will be fully aware of the weakness in Sterling. This may well make the Bank of England raise its inflation forecast in the next report due in November. GDP growth however, is currently moderating and looks set to slow to 1.5% in 2017 versus 1.8% in 2016 and will slow further to 1.3% in 2018. Employment growth has remained strong, although consumer spending has lost some of its positive momentum and credit conditions have tightened. This probably means the MPC are in a relatively neutral position and will continue to adopt the ‘wait and see’ stance. Many analysts believe that the first interest rate rise will come as late as the fourth quarter 2018, when there could be more clarity on Brexit.
Finally, the Bank of Japan has just experienced the sixth consecutive quarter of economic growth and this represents the longest run of growth in over a decade. A moderate rate of expansion (less than 2% GDP growth per annum) should continue, although any strength in the Yen is always a concern. Remember that as part of the central bank’s so-called yield curve control programme, the Bank of Japan aims to keep the 10-year bond yield close to 0.1%. The Bank of Japan are highly unlikely to consider unwinding until the repeatedly postponed 2% inflation target has been reached, perhaps in 2020. It will be tough to unwind, when you consider that they own virtually half of all Government debt.