US Federal Reserve
Another bout of soft labour market data in the US has raised the odds of the Fed doing more stimulus work, most likely in the form of an extension of “Operation Twist” which, absent an extension, is scheduled to end this month. For us the data remains consistent with our expectation of around 2% GDP growth this year which will be sufficient to see further modest employment gains and a gradual reduction in the unemployment rate. The important development for us over the past few months has seen increased signs of stability in the housing market, which adds some stability and sustainability to the (albeit modest) growth outlook. Last week’s inflation data added fuel to the debate with a petrol-price related drop in the annual rate of headline inflation to 1.7%. The annual rate of core inflation (more important for the Fed) was unchanged at 2.3%. I’m somewhat ambivalent towards more “twist”; I don’t think it adds much to the outlook for the real economy, but it doesn’t do any harm either. It’s simply a signalling tool for the Fed. As for more QE you know what I think: the Fed has done its job and the rest is structural (see India below on that point!). But if I were a dovish Fed, I might want to keep my powder dry and wait to know how big the fiscal cliff is in 2013 before I act.
European Central Bank
The ECB left interest rates unchanged at their last meeting, but left the door open to further cuts should economic and financial conditions deteriorate. There are clearly bigger issues in Europe than conventional monetary policy actions cannot cope with. We think interest rates will be cut again. A strong argument can be made for more targeted action from the ECB. As we argued last year, bond purchases through the Securities Market Program (SMP) can be justified on monetary policy grounds in countries such as Spain where a cut to the benchmark interest rate will do little to assist. The Spanish bank bailout has simply served to shift concern about the banks to the sovereign with the funds to be channelled through the government, adding to Spain’s sovereign debt ratio. In terms of the real economy, we expect Europe GDP to come in at around -0.5% for the year. That masks extreme divergence across the continent with significant recessions in countries implementing harsh austerity measures with stronger outcomes in Germany and France. Risk to growth is to the downside.
Bank of England
The Bank of England took no action in June, leaving both the benchmark interest rate (0.5%) and the asset purchase program (£325b) unchanged. An extension to the asset purchase program had been expected. More recently, however, the Government has announced £100b of cheap funding to the UK banking sector (through the Extended Collateral Term Repo Facility), reminiscent of the ECB’s LTRO program. The expectation of the Government and the BoE is that the banks will then lend these funds on to households and the SME sector. That remains to be seen. More QE is also likely as the risks have shifted to the downside for expected UK GDP growth of 1% this year.
Bank of Japan
No change in policy at the June BoJ meeting. The Bank was reasonably upbeat about the outlook for the domestic economy but that was largely based around earthquake reconstruction activity. However, we expect they may add to their ¥70t asset purchase program later this year, based largely on the expectation that they are likely to miss their new 1% inflation target without further stimulus. Indeed the IMF last week encouraged the BoJ to undertake a “powerful” easing to assist then in meeting their inflation target.
People’s Bank of China
The PBoC has made several cuts to reserve ratio requirement (RRR) in recent months and cut interest rates by 25bps earlier this month. Fiscal policy is also being eased via infrastructure spending and some subsidies for consumption. The slowdown in the economy has been accompanied by a cooling of inflation pressures with the CPI falling to 3.0% in May, creating room for further easing on all fronts (the official target is 4%). However we don’t expect aggressive policy action like we saw during the GFC. We expect further cuts to the RRR and another two 25bp cuts to deposit and lending rates. We also expect further fiscal easing, but authorities will also remain committed to better quality growth and rebalancing in the economy, ruling out aggressive action on this front too. That is based on our expectation of GDP growth bottoming out in the current quarter at around 7.5% with a modest recovery into the second half of the year.
Reserve Bank of India
The limited room to move on monetary policy in India was highlighted this week with the decision by the Reserve Bank of India to leave interest rates unchanged at 8% (the repo rate) and the cash reserve ratio unchanged at 4.75%. We have previously discussed the challenges for India are mainly structural and that fiscal policy (subsidies) is too loose. The RBI seems to agree. The RBI said : “Our assessment of the current growth-inflation dynamic is that there are several factors responsible for the slowdown in activity, particularly in investment, with the role of interest rates being relatively small”. They went on to say that a “Further reduction in the policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures”. Inflation rose to 7.55% (the WPI or Wholesale Price Index) last month shortly after it was announced that GDP growth had slowed to 5.3%. They clearly believe the Government has a significant role to play in improving the growth/inflation balance saying that the decision to front load an Interest rate cut in April was based on the premise the Government would be undertaking a program of fiscal consolidation and other supply side initiatives. The stage is set for an interesting policy debate.
Central Bank of Brazil
Brazil has continued to ease monetary conditions in the face of a sharply weaker economy. The benchmark Selic rate is at an historic low of 8.5%. The slowdown in the economy has been contained to the industrial sector and business investment reflecting the high exchange rate and the slowdown in external demand (Europe). Consumption growth remains solid and the unemployment rate is at record lows. That means (you guessed it!) a structural response is required here too, particularly in the labour market. A recovery in growth at (over?) full employment suggests further upward pressure on labour costs and a quick return to high inflation. We wouldn’t rule out further interest rate cuts, but the more they cut from here, the more we start to worry about inflation next year.
Australia and New Zealand
We have seen two recent rate cuts by the Reserve Bank of Australia: 50 basis points in May followed by 25 in June. The June rate cut was swiftly followed by stronger than expected GDP and employment data. That caused our team in Sydney to call a pause to further near-term rate cuts, but they believe the door is open for more cuts later this year. In New Zealand we believe the RBNZ’s bias to hike rates is right, but we won’t see a start to the tightening cycle from the current OCR of 2.5% until mid-2013. Our projected OCR peak remains at 4.5%, significantly lower than historical highs.