Global central bank rate hikes: part solution, part problem

Too little attention has been paid to the global rise in central bank policy rates in the past 6-7 months and its implications for economic growth, CPI-inflation and currency and rates markets.

Central bank rate hikes in Emerging Market (EM) economies, along in some cases with central bank FX intervention and other policy measures, have helped stabilise under-pressure currencies, particularly high-yielders.

Tighter EM monetary policy has in turn helped arrest the rapid rise in core and in particular headline CPI-inflation.

Moreover, developed central bank rate hikes have arguably contributed to relatively stable core CPI-inflation of around 1.5% yoy.

However, our analysis also suggests that the 50bp increase in the global policy rate over that period to a seven-year high of about 2.8% has contributed to a slowdown in global GDP growth to a seven-quarter low of about 3.2% yoy in Q4 from 3.6% yoy in Q2 and will continue to weigh on economic growth in coming quarters.

There is already compelling evidence that GDP growth slowed in the US and UK in Q4 and remained weak in the Eurozone.

We forecast that global GDP growth will slow below 3% next year which, along with lower international crude oil prices, will contribute to an easing in inflationary pressures.

If this scenario pans out, the risk is that the pace of global central bank rate hikes (including in the US) will moderate, potentially quite sharply.

 

This will be the last FIRMS report for the year with publication to resume in the new year. We would like to wish you and your families a happy festive season.

 

Implications of widespread central bank rate hikes under-estimated

A number of themes have understandably hogged the headlines this year, including the souring of US-Sino trade relations (and its implications for domestic and global growth), the ongoing investigation of possible collusion between US President Trump’s team and Russia, the signing of a new NAFTA deal, Brexit, Italy’s run-in with the European Commission and this summer’s emerging market (EM) wobble. The US Federal Reserve’s likely pace and magnitude of policy rate hikes have, as often the case, been an omnipresent concern for policy-makers worldwide and financial markets.

However, too little attention has been paid to the global rise in central bank policy rates in the past 6-7 months and its implications for economic growth, inflation and currency and rates markets. Central bank rate hikes in EM economies, along in some cases with central bank FX intervention and other government-led measures, have helped stabilise under-pressure currencies and arrest the rapid rise in core and in particular headline CPI-inflation. Moreover, developed central bank rate hikes have arguably contributed to relatively stable core CPI-inflation (which excludes more volatile food and energy prices) of around 1.5% yoy, according to our estimates. The result is that global core CPI-inflation has remained in the narrow 1.8-2.2% yoy range in place since summer 2013.

 

 

However, our analysis also suggests that the 50bp increase in the global policy rate over that period has contributed to a slowdown in global GDP growth to a seven-quarter low of about 3.2% yoy in Q4 from 3.6% yoy in Q2 and will continue to weigh on economic growth in coming quarters. Our overall take-away is that global growth starts being inflationary when it exceeds about 3.5%, although a large number of variables including productivity growth and global energy/commodity prices condition the “threshold” for this growth/inflation trade-off.

We forecast that global GDP growth will slow below 3% next year, inflationary pressures will ease and therefore that the pace of global central bank rate hikes (including in the US) will moderate, even if a number of major central banks, including the European Central Bank (ECB) and Reserve Bank of Australia, slowly start hiking their policy rates towards end-2019.

 

Metronomic, globalised rise in central bank policy rates since April

A GDP-weighted average of major central banks’ nominal policy rates has risen 50bp since April to a seven-year high of about 2.8% (see Figure 1). To put this in perspective, the global policy rate had hovered in a narrow range of 2.1-2.3% in the previous three years. At sub-3% the global policy rate is still low in level terms compared to the pre-2008 crisis period when it exceeded 5% but the 20% increase since April is notable. Moreover, the Federal Reserve’s 75bp of rate hikes since the spring account for “only” 21bp of this 50bp increase in the global policy rate, according to our estimates, because simply put the Fed is no longer the only hiking central bank in town – a point which we first made Crunch time for currencies ahead of pivotal Q4 (24 September 2018).

 

 

Admittedly, the majority of developed central banks have so far either kept their policy rates unchanged (including in the Eurozone, Japan, Switzerland, Australia and New Zealand) or hiked rates only 25bp (e.g. the United Kingdom) and are unlikely to hike rates any time soon, in our view. However, a growing number of both developed and EM central banks have this year jumped on the rate-hiking wagon, albeit for somewhat different reasons (see Figure 2), or in the case of the ECB started to cut its QE asset purchases.

  • The Bank of Canada, Norges Bank and Riksbank have hiked their policy rates 50bp, 25bp, 25bp respectively, in the face of reasonably robust economic growth spurring (still modest) inflationary pressure.
  • In EM, the central banks of Argentina and Turkey have had to deliver potent rate hikes to stabilise their collapsing currencies and bring down soaring CPI-inflation. Central banks in the Czech Republic, India, Indonesia, Korea, Malaysia, Mexico, the Philippines, Romania, Russia and South Africa have also hiked rates, albeit far more modestly, to provide currency support and counter domestically-generated inflationary pressures.
  • Only three major central banks have cut their policy rates year-to-date: Brazil, Colombia and Peru, by 50bp each (see Figure 2). The last central bank to cut rates was Banco Central de Colombia back on 27th April (see Appendix, Figure 15). The People’s Bank of China (PBoC) also announced on 7th October that it was cutting by 100bp the Reserve Requirement Ratio (RRR) for small and big banks to respectively 12.5% and 14.5%, effective 15 October.

 

Emerging market central bank rate hikes have contributed to (modest) currency rebound

Central bank rate hikes in EM economies along, in some cases, with central bank FX intervention and other government-led measures, have helped stabilise under-pressure currencies and arrest the rapid rise in core and in particular headline CPI-inflation, in our view.

EM currencies  weakened sharply during the summer, partly as a result of currency crises in Argentina and Turkey, (limited) contagion to other high-yielding EM currencies (e.g. the Indonesian Rupiah) and the PBoC’s explicit depreciation of the Chinese Renminbi (see Lira collapse post-mortem: Contagion lite, 17 August 2018, and Renminbi devaluation “lite”: Tool and weapon, 29 June 2018).

Specifically a GDP-weighted basket of EM Nominal Effective Exchange Rates (NEERs) excluding the Chinese Renminbi depreciated over 3% in the five weeks to 10th September to a multi-year low, according to our estimates (see Figure 3). A GDP-weighted basket of high-yielding EM currencies (ARS, BRL, COP, IDR, INR, MXN, RUB, TRY and ZAR)[1] weakened almost twice as fast (see Figure 4).

 

 

 

However, since 10th September this basket of EM NEERs excluding the Renminbi has appreciated by (an admittedly modest) 2% (see Figure 3), led by a rally of almost 4% in high-yielding currencies (see Figure 4). While the relative “cheapness” of EM currencies likely attracted FX inflows and relative-value trades, the tightening of EM monetary policies alongside reflationary government policies also likely played a role in our view (see Figure 5).

 

 

Specifically, in the past 3-4 months the central banks of:

  • Argentina and Turkey have hiked their policy rates 1,500bp and 625bp, respectively, in the face of acute pressure on their currencies (see Figure 2);
  • Russia, Mexico and the Czech Republic and Indonesia have hiked their policy rates 50bp;
  • South Korea and the Philippines have hiked their policy rates 25bp; and
  • Even the reticent South African Reserve Bank (SARB) finally hiked rates 25bp on 22nd November – the first rate hike since March 2016.

 

Uptick in Renminbi likely the product of subtle Chinese policy shift

Moreover, the PBoC has lowered the USD/CNY fix about 0.8% in the past three weeks, contributing to a 0.7% fall in USD/CNY spot and a 0.4% rise in the Renminbi NEER (see Figure 6). We think this subtle policy change reflects Chinese (and US) efforts to thaw trading relations.

US President Trump and Chinese leader Xi Xiping (in the context of the G20 meetings) announced on 2nd December that the US would delay by 90 days its planned increase in tariffs to 25% from 10% on $200bn of Chinese imports and that China would reciprocate by not increasing tariffs either. Moreover, the Chinese Finance Ministry announced on 14th December that it would cut tariffs on car imports from the US from 40% to 15% for 3 months, starting on 1st January (bringing them in line with tariffs on car imports from other countries) and that it would suspend its additional 5% tariff on imports from the US of 67 other auto parts.

This was in line with our view that “The fact that both US and Chinese economic growth appear to be slowing may, at the margin, incentivise both sides to consider unwinding some of the import tariffs currently in place and at the very least put on hold threats to introduce further import tariffs. This could in turn see the Renminbi NEER push higher but we think the PBoC will want to keep a tight leash on its currency.” (see Black Friday Currency Sale: Bargaining Hunting, 23 November 2018).

 

 

Higher EM policy rates and currency rebound likely to lower inflation going forward

The lagged, historical relationship between central bank policy rate changes and CPI-inflation suggests that the tightening of EM monetary policy in the past six months, resulting from central bank policy rate hikes and modestly stronger currencies, is likely to lower core and headline CPI-inflation in coming months (see Figure 7). The lag, which we estimate at about six months, is partly due to lags in the transmission mechanism between official policy rates, commercial bank rates, domestic demand and finally wholesale and consumer prices.

 

 

Moreover, the 40% fall in the international Brent crude oil price since early October will – assuming it is not reversed – contribute to lower headline CPI-inflation in coming months (with the lag due in part to the stickiness of the transmission mechanism between international, wholesale and retail prices and the tax wedge). This in turn would help temper expectations of higher inflation and wage demands and ultimately curb domestic demand and core CPI-inflation, in our view.

 

Headwind to global economic growth from higher central bank policy rates

While central bank policy rate hikes in recent months will likely help reverse the recent rise in global and in particular EM inflation, there is also evidence that tighter monetary policy has weighed on global economic growth and will continue to do so in coming quarters. If the robust historical, lagged relationship between the global central bank (nominal) policy rate and global GDP growth holds going forward, GDP growth will weaken below 3% year-on-year in the next couple of quarters (see Figure 8).

 

 

Based on data for economies which account for nearly 80% of world GDP, we estimate that year-on-year GDP growth slowed by nearly 0.3 percentage points in Q3 to below 3.5% – its slowest rate since Q4 2016 – while quarter-on-quarter growth edged below 1% for the first time since Q1 2017 (see Figure 9).

 

 

 

This global growth slowdown ties in with the fall in the ongoing fall in the global manufacturing Purchasing Managers Index (PMI), including in Q3 (see Figure 10). Moreover, the further downturn in the PMI in October-November to 52.0 suggests that global GDP growth continued to slow in Q4 to around 3.2% yoy according to our estimates. There is corroborating evidence at a country and regional level that GDP growth slowed in Q4 2018.

In the US, the Atlanta Fed GDPNow tracker puts US GDP growth at 2.9% quarter-on-quarter annualised in Q4, down from 3.5% in Q3 and 4.2% in Q2. This is in line with our own forecast of 3.0% derived from the historical relationship between the average of the New York Fed and Philadelphia Fed manufacturing indices (which fell to a two-year low of 16.6 in Q4) and US GDP growth (see Figure 11).

 

 

 

In the Eurozone, the fall in the composite PMI to a multi-year low of 52.6 in Q4, suggests that Eurozone GDP growth, which slowed to a four-year low of just 0.16% qoq in Q3, did not recover materially in Q4 and may have edged lower (see Figure 12). The German car industry’s struggle to meet new EU emission standards and the recent national strikes and demonstrations in France likely contributed to weak growth in the European’s Union’s largest and second largest economies.

In the UK, the National Institute of Economic and Social Research (NIESR) estimates that GDP growth slowed to 0.3% qoq in September-November from 0.6% qoq in Q3 and will hit only 0.4% qoq inQ4.

 

Slowing economic growth, modest inflationary pressures…hiking cycle close to maturity?

If our forecasts of lower global economic growth and CPI-inflation in 2019 prove correct, we would expect the pace of central bank rate hikes to slow on the whole. Some developed and EM central banks may of course continue (or even start) to hike policy rates, to stabilise under-pressure currencies and/or lean against rising inflationary pressures. However, the risk is biased towards central banks slowing or even pausing their rate hiking cycles, in our view. Policy rate cuts, which have all but disappeared since the spring, may yet resurface in the second half of 2019.

The elephant in the room will of course be the Federal Reserve. As expected it hiked its policy rate 25bp on 19th December to 2.25-2.50% (the fourth and final rate hike for 2018) but FOMC members cut their expectations for rate hikes in 2019 by almost 25bp. Specifically the 17 FOMC members[1]  revised downwards their September 2018 policy meeting estimate that 70bp of rate hikes would be appropriate to 47bp (i.e. just short of two full hikes), according to our estimates (see Figure 13). Nevertheless, this is still more than three times as much as the 15bp of rate hikes in 2019 which the market is currently pricing in.

At this early stage, we think that the Federal Reserve will hike once in 2019 (“one and done”). The Dollar has proved resilient in recent weeks (see Figure 14) but we maintain our view, first expressed three months ago, that “as markets head into 2019 the Dollar could become more vulnerable” (see Crunch time for currencies ahead of pivotal Q4 (24 September 2018).

 

 

APPENDIX

 

 

[1] Argentine Peso, Brazilian Real, Colombian Peso, Indonesian Rupiah, Indian Rupee, Mexican Peso, Russian Rouble, Turkish Lira and South African Rand.

[2] There were 15 FOMC members at the June 2018 meeting, 16 at the September meeting (Richard Clarida was appointed to the FOMC Board of Governors in late August) and 17 at the December meeting (David Bowman was appointed to the FOMC Board of Governors in November).