Monday, March 21, 2016

Central bank stock-take

March meetings of the world’s major developed central banks are now behind us with one becoming less hawkish, one doing nothing and one firing a bazooka.  That combination has been enough to ease some of the concerns about the outlook for the global economy and has contributed to the recent rally in risk assets.  An important consideration however is with money policy already very easy, how much more effective can central banks be?

We thought the Federal Open Market Committee would drop one or at most two hikes from their interest rate track for 2016.  In the end they come in at the dovish end of the spectrum by taking two out and effectively removing any chance of an interest rate increase before June.   This is now closer to market expectations of around a 70% chance of one hike before the end of the year.

The issue for the FOMC was the extent to which they would balance upward momentum in key inflation indicators against the message about US and global growth contained in the market turbulence we saw at the start of the year.  In the end the message from the Committee is they are wary of doing anything that will undermine the outlook for economic growth, including the impact on the US economy of a stronger US Dollar if they continued tightening while the ECB and BoJ are still easing.

This now brings the FOMC into line with our thinking of two hikes this year with a risk profile that is somewhat more symmetrical, especially in the out-years. If growth disappoints they may do less; if inflation continues to move higher, they may do more.  In the meantime, markets have a chance to take a deep breath and time and space to reflect underlying fundamentals.

The Bank of Japan did nothing in March.  There are probably a number of reasons for that: they’ve only just done something, what they did backfired to some extent and they must also be concerned they may have exhausted their ability to be effective.  

The adoption of a Negative Interest Rate Policy (NIRP) earlier this year was probably aimed at increasing inflation expectations ahead of the spring wage negotiations.  For a sustained increase in underlying inflation, a sustained increase in unit labour costs is required.  The adoption of NIRP led to generalised concern about the health first and foremost of the banking sector and the economy.  As a result, wage claims this year are averaging around 0.4%, lower than last year’s 0.7%.   That seems likely to lead to a FALL in unit labour costs and downward pressure on inflation.

It’s inevitable the BoJ will revise down their growth and inflation forecasts at their April meeting. All else being equal, that would probably lead them to ease further at that time, but that is not guaranteed.  Further action from here will be most effective if it lifts inflation expectations.  The Bank may wait for the dust to settle on NIRP before doing more.  The answer to higher growth lies with the Government and fiscal policy – the most likely first cab off the rank in that regard will be postponing next year’s consumption tax increase.

The European Central Bank fired a bazooka earlier in the month, throwing everything except the kitchen sink at the problem of persistently low inflation in the Eurozone.   The ECB has similar issues to the BoJ in that they are missing their inflation target by a large margin.  Core inflation in the Euro zone is also 0.7%, the same level as Japan.

In March the Bank expanded their asset purchase program, cut interest rates and announced new Targeted Long-Term Refinancing Operations (TLTROs).  The good news is we think the ECB has a greater chance of impacting the real economy than the BoJ.  We’ve long stated the most effective of the ECB’s measures was their TLTRO programme which has been successful in helping unlock credit growth in the region, so we were pleased to see this component in their recent package of measures.

That said, with the unemployment rate still at 10.3% across the Eurozone, it will be some time before we see wage growth putting sustained upward pressure on inflation, which means there’s still a good chance the ECB does more.