How the Fed interest rate rise and other central banks’ monetary policies have left financial markets all jittery
Nicholas Spiro says the divergence in monetary policy among the Federal Reserve, European Central Bank and Bank of Japan has unsettled investors
Late last year, most investment strategists believed 2018 would be the year that would mark a decisive shift towards the normalisation of monetary policy.
Central-bank watchers expected the Federal Reserve, under its new chair Jerome Powell, to accelerate the process of raising interest rates and shrinking its US$4.5 trillion balance sheet. They also anticipated that the European Central Bank would announce the end of its quantitative easing (QE) scheme. Some analysts even expected the Bank of Japan, which is furthest away among the big three central banks from normalising policy, to raise its target for 10-year government bond yields slightly as inflation showed signs of picking up.
Fast forward six months, and most of these predictions have proved accurate. Yet just a cursory glance at the decisions taken at last week’s meetings of the main central banks shows that the path to policy normalisation is a long and winding one, with many pitfalls lurking along the way. The only central bank which, for the time being, is determined to push forward is the Fed.
Indeed the most striking feature of last week’s meetings is the stark divergence in policies between the leading central banks, especially between the Fed and the ECB, which are both taking measures to withdraw stimulus.
Here is a brief guide to the disparate policy trajectories of the world’s leading central banks and their implications for markets.
The pacesetter: the Fed is setting the pace in unwinding its ultra-loose monetary policies and is turning more hawkish under Powell. Not only is the US central bank, which raised rates for the seventh time since December 2015 last Wednesday, anticipating two more increases this year, it is also exuding confidence about the outlook for America’s economy, forecasting growth of nearly 3 per cent this year and a further fall in unemployment to just 3.5 per cent next year, the lowest rate since the 1960s.
With the Fed’s preferred measure of inflation having already hit the central bank’s target of 2 per cent and new forecasts from Fed policymakers anticipating that rates will reach 3.4 per cent in 2020 – above their estimate for the neutral rate in the longer term – US monetary policy is on track to move into restrictive territory. This increases the scope for a “hawkish policy mistake” – the biggest concern of global fund managers right now– particularly given mounting fears in the US business community about the effects of a trade war.
The hedger: while the Fed is pushing ahead decisively, the ECB is hedging its bets. While Europe’s central bank has decided to end its QE programme in December, it will not start to raise rates before the second half of 2019. There is now a high probability that Mario Draghi, whose term as ECB president expires in October next year, will leave the central bank before rates begin to rise.
The ECB’s reluctance to remove stimulus stems mainly from the recent slowdown in Europe’s economy. Industrial production contracted in the euro zone’s four largest economies in April, with investor confidence in export-led Germany plunging to its lowest level since 2012 due to the acute vulnerability of Europe’s largest economy to rising protectionism. Fears about Italy’s commitment to the euro, moreover, are adding to the uncertainty.
The outlier: While the ECB is moving in the direction of the Fed, the Bank of Japan is keeping its aggressive QE scheme and yield-control target firmly in place. At his press conference last Friday, Haruhiko Kuroda, the bank’s governor, even pointed to the challenge posed by a “deflationary mindset” that “doesn’t exist in the US or Europe.” With core inflation slipping further away from the bank’s 2 per cent target, Japan will keep the QE ball rolling for some time.
These three distinct policy trajectories have significant implications for markets.
The most important one is that the Fed’s hawkishness has just given the US dollar a further boost, boding ill for emerging market assets whose sharp price declines over the past two months were triggered by the greenback’s sudden revival.
Another key implication for markets is that the stakes are rising for the euro zone. Not only will the end of QE in December prove to be a pivotal moment for Europe’s bond markets – in particular Italy’s – which have benefited the most from ultra-loose monetary policy, the ECB’s decision to keep its borrowing costs in negative territory for longer than expected will place Europe’s vulnerable banks under more pressure.
Not long ago, the world’s leading central banks were a source of stability for jittery markets. Yet, as last week’s conflicting signals show, global monetary policy is now a major contributor to the recent surge in volatility.
Nicholas Spiro is a partner at Lauressa Advisory