Global Central Bank Easing Nearing Important Inflexion Point
Recent comments from the Fed, ECB and BoJ have rattled financial markets after a summer of relatively low volatility.
The correction in financial markets has so far been relatively modest, particularly for equities and the dollar. But the questions remain where global monetary policy goes from here, the implications for asset valuations and ultimately whether elevated global risk appetite will correct more forcefully.
My core view is that eight years of ultra-low (and in some cases negative) central bank policy rates and expansive bond-buying programs have helped stabilise global growth and inflation, albeit at low levels.
At the same time, the costs of ultra-loose monetary policy, including asset price bubbles, distortions in bond markets, pressure on the banking sector and even rising inequality, may be starting to outweigh the benefits.
Therefore, major central banks, with the exception of the BoJ, may refrain from loosening monetary policy further near-term.
I would certainly expect central bank policy rate cuts to become increasingly less frequent than in the past and the ECB and BoE to keep the modalities of their current QE programs broadly unchanged for now.
At the very least, the world’s most influential central bankers may going forward tweak a discourse which has in recent years largely focused on doing “whatever it takes”.
To be clear, the risk near-term remains biased towards more central bank monetary policy easing. Bar the Fed and possibly a handful of EM central banks still fighting weak currencies and high inflation, no major central bank is likely to hike policy rates or tighten monetary policy this year, in my view. That’s a story for 2017, at the earliest.
But if we have indeed reached an inflection point in global central bank monetary policy, if anything financial markets will become more sensitive to any downturns in still tepid global growth and inflation and to the negative side-effects of loose monetary policy.
In this context higher volatility is likely to prevail and global risk appetite may struggle to forcefully regain traction for now.
Markets, spooked by Fed, ECB and BoJ statements, looking to next central bank moves
A trifecta of announcements in the past week from the US Federal Reserve (Fed), European Central Bank (ECB) and Bank of Japan (BoJ) have rattled financial markets after a summer of reasonably low volatility. Long-end yields have spiked, global equities have lost their footing, albeit from a 12-month high, the VIX has spiked (see Figure 1) and the US dollar has appreciated nearly 1.5% (see Figure 2).
FOMC members setting their stall prior Fed meeting but data working against the hawks
A number of Federal Open Market Committee( FOMC members), including Boston Reserve Bank President Rosengren (voter) and San Francisco Reserve Bank President Williams (non-voter) have in the past week added to the steady stream of hawkish comments from Vice-Chairmen Fischer and Dudley and Kansas City Reserve Bank President George (all voters) prior Jackson Hole.
Their apparent support for an early Fed rate hike temporarily bumped market pricing for a Fed hike on 21st September to 9bp from only 5bp a few days before. Outright dovish comments from Board Governor Brainard (voter) on 12th September and weak retail sales and industrial output data for August (released on 15th September) have cut back market pricing for a hike next week to a meagre 3bp. But neither Brainard nor US data, which seemingly put a hike next week out of reach, have stopped the US Treasury yield curve from steepening (see Figure 3).
ECB seemingly content with current monetary policy stance
ECB President Draghi said in his press conference after the ECB policy meeting on 8th September that the eurozone’s central bank had not discussed an expansion or lengthening of its current quantitative easing program (which formally ends in March 2017), causing the German Bund yield curve to bear steepen.
BoJ has done little to assuage concerns that negative rates have worked or will work
Finally, BoJ Governor Kuroda last week publicly acknowledged for the first time the damage from negative policy rates (of -0.1%) to Japanese banks’ profits and rates of investment returns. The bear-steeping of the Japanese bond yield curve and the yen’s appreciation (see Figure 2) suggest that markets expect the BoJ to cut interest rates further at its policy meeting on 21st September but that this will have no material or lasting impact on inflation or the yen (and may well indeed have costs).
In the greater scheme, the correction in financial markets has so far been relatively modest, particularly for equities and the dollar. But policy-makers have seemingly (re) ignited concerns that ultra-loose monetary policy in Japan has not been particularly effective and if anything may be losing its effectiveness and that, somewhat contradictorily, it is too early for the ECB not to loosen policy further let alone for the Fed to hike rates. Comments from Fed, ECB and BoJ officials have led to a more meaningful soul-searching about where global monetary policy goes from here, the implications for asset valuations and ultimately whether elevated global risk appetite will correct more forcefully.
Global monetary policy approaching holding pattern
My core view is that eight years of ultra-low (and in some cases negative) central bank policy rates and expansive bond-buying programs have helped stabilise global growth and inflation, albeit at low levels. At the same time, the costs of ultra-loose monetary policy, including asset price bubbles, distortions in bond markets, pressure on the banking sector and even rising inequality, may be starting to outweigh the benefits.
Therefore, major central banks, with the exception of the BoJ, may refrain from loosening monetary policy further near-term. I would certainly expect central bank policy rate cuts to become increasingly less frequent than in the past and the ECB and Bank of England (BoE) to keep the modalities of their current quantitative easing (QE) programs broadly unchanged for now. At the very least, the world’s most influential central bankers may going forward tweak a discourse which has in recent years largely focused on doing “whatever it takes”. To be clear, bar the Fed and possibly a handful of EM central banks still fighting weak currencies and high inflation, no major central bank is likely to hike policy rates or tighten monetary policy this year, in my view. That’s a story for 2017, at the earliest.
But if we have indeed reached an inflection point in global central bank monetary policy, financial markets will want hard evidence that central banks have not prematurely stopped cutting rates or expanding QE and that if GDP growth and inflation start to slow again policy-makers have more policies, whether conventional or not, up their sleeves. In this context, financial markets are likely to become more sensitive to any downturns in still tepid global growth and inflation and to the negative side-effects of loose monetary policy, and higher volatility is likely to prevail.
While the list of variables that a central bank will analyse and weigh is almost endless, the most obvious measures of whether global monetary policy has worked are economic growth and inflation (the explicit target for most central banks) and I start with the relationship between central bank policy rates and global real GDP growth.
Global GDP growth stabilising at last
Global GDP growth slowed, in year-on-year terms, for nine consecutive quarters up till Q1 2016, according to my estimates based on data for economies accounting for over 95% of world GDP (see Figure 5). But this gradual erosion, rather than collapse in global growth, has been unique in the past 20 years as growth has tended to either rise sharply as in 1999-2000, 2002-2004 and 2009-2010 or fall sharply as in 1998, 2001, 2008 and 2011-2013 (see Figure 6). Moreover, global GDP growth was broadly stable in Q2 2016 at 2.8% yoy – albeit at a 4-year low – and may have risen to around 2.9% yoy in Q3 based on global manufacturing PMI data for July-August (see Figure 5).
While central bank rate cuts did not stop global GDP growth from slowing in recent years, along with QE programs in the US, UK, Eurozone and Japan lower policy rates likely prevented the kind of growth meltdown recorded in late 2008 (see Figure 7). In that sense they were far from an unmitigated failure. Interest rate policy appears to lead global growth by about four quarters and so it is conceivable that the 42 policy rate cuts by major central banks since June 2015 will be slowly driving global growth in coming quarters.
But Figure 7 suggests that rate cuts have lost some of their potency so any improvement in global growth is likely to be very modest. The evidence that rate cuts and QE have boosted lending, investing and borrowing has so far been mixed at best and looser monetary policy has done little to drive global productivity growth. Moreover, governments have so far shown little appetite (or ability) to step into the breach by loosening fiscal policy.
Threat of global deflation has receded but inflation still low by any metrics
The picture which emerges is that lower central bank interest rates have helped put a floor under GDP growth which has in turn helped stabilised global CPI-inflation particularly in emerging markets, albeit at low levels (I acknowledge that most central banks have their preferred measures of inflation, be it market-based CPE inflation in the US, a combination of WPI and CPI in India or trimmed CPI-inflation in Australia).
A GDP-weighted basket of headline CPI-inflation inched up to 1.5% yoy in July, 0.5 percentage points higher than in September 2015 according to my estimates based on economies accounting for 85% of world GDP (see Figure 8). However, headline CPI-inflation remains low by historical standards in most major economies (see Figure 9).
The rise in global headline CPI-inflation has admittedly been glacial but this partly reflects depressed energy and food prices over which central banks have little or no control. A GDP-weighted basket of core CPI-inflation inched up to a 17-month high of 2.0% yoy in July (see Figure 10).
The US stands out amongst the larger economies, with core CPI-inflation of 2.3% in August well above the 1.8% average since January 2013. Where inflation goes next is of course the subject of much discussion, but at these inflation levels the debate is seemingly not whether the Fed will hike but when. In Sweden, Norway and Switzerland, where central banks of course set interest rate policy independently of the ECB, headline CPI-inflation has risen to the high end of their ranges (see Figure 11).
While global deflation may have been avoided for now, global headline CPI-inflation remains near the bottom of the range in place since January 2013 (see Figure 9). Core inflation is running only slightly above average (see Figure 11) thanks mainly to the US, Canada, Norway and a handful of non-Asian emerging markets economies. Moreover, partial data suggest that global CPI-inflation may have fallen in August due to falls in core CPI-inflation in the eurozone, Brazil, China, Czech Republic, Denmark, Hungary, Indonesia and Norway.
Indeed, CPI-inflation remains historically weak in most major economies, based on latest monthly data.
- Headline CPI-inflation is near-zero in the eurozone, Denmark, New Zealand, Korea and Thailand and still negative in Japan, Switzerland, Hungary, Poland and Romania.
- Core CPI-inflation was -0.4% yoy in Poland in, zero in the Czech Republic and Switzerland and only 0.3% yoy in Japan.
There is some evidence that looser monetary policy has helped stabilise global GDP growth and inflation but its negative-side effects are also coming into greater focus. There are many schools of thought about what policy-makers should and will do next. These range from “helicopter money”, at one extreme, to central bank rate hikes and an unwinding of QE programs at the other. The IMF’s recommendation of further monetary policy easing and in particular infrastructural spending falls somewhere in the middle of this spectrum.
I would argue that the number of central bank cutting policy rates, which peaked in the first half of 2015, will fall further going forward (see Figure 12).
The global real policy rate, using core-CPI inflation as the deflator, has fallen sharply in recent years (see Figure 14) and was in July 39bp below the average since end-2008 (see Figure 13). Only a handful of central banks, including in Russia and India, currently have real policy rates significantly above their long-term average (see Figure 13). Note that the conclusion is broadly similar if we deflated the Reserve Bank of India’s policy rate with core CPI-inflation.
Given the resilience of the UK economy post referendum, I expect the BoE for now to refrain from cutting its policy rate to the psychologically-sensitive level of 0% and from expanding its current QE program. Similarly, I don’t expect ECB to cut its policy rates or increase and/or lengthen its QE program at this stage.
If global growth and inflation continue to slowly rise, further rate cuts and/or expansions of QE programs are likely to become the exception rather than the norm and are likely to be less dramatic perhaps than in the past. At the very least, it is conceivable that central bank rhetoric will evolve, taking into greater account the need and usefulness of further monetary policy loosening.
Risk near-term still biased towards more central bank monetary policy easing
To be clear, the risk near-term remains biased towards more central bank monetary policy easing, particularly if the likely fall in global CPI-inflation in August isn’t temporary. There is evidence that policy rate cuts have lost some their potency and governments are unable or unwilling to loosen the fiscal strings despite a timid recovery in global growth and inflation from a very low base still in its infancy.
Major central banks could argue that real policy rates are still above their long-term averages, as I did in Right or wrong, further central bank rate cuts still on the cards, 19 August 2016). A GDP-weighted average of major central banks’ nominal policy rate minus headline CPI-inflation (ex-post) was in July 14bp above its 10-year average (see Figure 15).
In particular, Russia, most Asian economies and to a lesser extent the UK and eurozone currently have central bank real policy rates which are above their long-term averages (see Figure 16). The BoJ could conceivably further cut its current policy rate of -0.1%, and the ECB and more forcefully the BoE have kept the possibility of further rate cuts and/or expansions of their QE programs firmly on the table. With the omnipresent threat of Brexit still weighing on the British economy, I would at the very least expect the BoE to keep sterling on the back foot by leaving open the possibility of further easing measures.
Certainly no central bank, bar the Fed and a handful of EM central banks still fighting weak currencies and high inflation is likely to hike policy rates or tighten monetary policy any soon (that’s a story for 2017 at the earliest). Figure 12 shows that since end-March only two have hiked their policy rates – Mexico in June and Nigeria in July.
Even the Fed has repeatedly stressed that any future rate hikes would be modest and gradual, a point it will likely reaffirm regardless of whether it decides to hike rates next week. FOMC Board Governor Brainard in particular emphasised the shortcomings of the US labour market, a view which I share. In Fed – sense of déjà-vu (7 September 2016) I argued that there is still slack in the US labour market, with aggregate weekly payrolls in the private sector rising only 3.5% yoy in August, which in turn was likely taming inflation.