The Fed, Bank of Japan and ECB are all signalling that the rate-tightening era may have passed … for now

The Fed has slowed its rate hikes, while there’s no sign of any monetary tightening at the BOJ and ECB right now. This could be good news for Hong Kong and risk assets, at least in the short term

Tai Hui

Published: 10:31am, 22 Feb 2019

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At the start of each year, managers are usually busy setting objectives for their teams. These targets should be challenging enough to test the team’s ability and strive for improvement. They should also be realistic. Central banks also have long been adopting policy objectives, usually targeting a certain level of inflation. For some, such as the US Federal Reserve, they also have additional mandates, such as full employment. Indeed, maximising jobs and stabilising prices are the key dual mandates of the Fed’s monetary policy.

Ten years after the financial crisis, the US central bank has achieved its objective of full employment, with the American jobless rate at a multi-decade low. The Fed is also quite close to its inflation target of 2 per cent, which has helped to justify its steady rate hikes in recent years.

However, for other central banks, inflation targets remain elusive and, at times, unrealistic. The European Central Bank (ECB) and the Bank of Japan also have their inflation targets set at 2 per cent. In Europe, inflation did approach 2 per cent in 2018, and this prompted the ECB to end its asset purchase programme at the end of 2018. It also raised speculation that it could raise interest rates in 2019. A sharp deterioration in data in recent months has quickly reversed market expectations. The region’s economy barely grew in the second half of 2018, with Italy in contraction. The ECB’s inflation target is certainly challenging, and looking increasingly far-fetched in the near to medium term.

In Japan, structural factors have prevented the economy meeting the BOJ’s 2 per cent inflation target, despite negative interest rates and aggressive government bond and exchange-traded fund purchases. These include negative population growth, financial institutions that are cautious about lending and conservative consumer sentiment. Relative to the US and euro zone, Japan’s inflation target has always seemed unrealistic. Since the 1990s, Japan has only experienced 2 per cent inflation for two reasons, a spike in oil prices or an increase in the goods and services tax. Neither of these sources are generating the type of inflation that the BOJ is looking for, which is brought about by strong domestic demand.

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What this means is that markets’ fear of financial tightening by central banks could be assuaged sooner than expected. In 2018, markets were worried that the Fed could raise rates too aggressively, choking US economic growth and bringing troubles to emerging markets. The combined asset purchase programmes by these three central banks were also expected to swing from net buying to net selling this year. A practical result would have been a withdrawal of liquidity, removing a form of support that has bolstered the prices of risk assets in the past few years.

What is the reality now? The Fed is taking a much more patient approach on rate hikes, which could also slow its balance sheet reduction in the coming quarters. The window for the ECB to raise interest rates has probably passed. The BOJ is still deeply engaged in quantitative easing, limited only by the already enormous share of the Japanese government bond it owns relative to the market (over 40 per cent). The People’s Bank of China is also loosening its monetary policy by reducing reserve requirements and encouraging banks to lend more.

China isn’t alone in facing policy uncertainties: look at the Fed and ECB

Should we cheer this development? Global equities certainly greeted it with enthusiasm and have already rebounded strongly since the start of 2019 in response to the change in central banks’ stance. Corporate debt and emerging market bonds have also recovered. Markets believe that the Fed’s caution could prolong this growth cycle. Pressure on Hong Kong interest rates to rise further is arguably reduced if the Fed is already close to the peak of its hiking cycle. This could help provide some support to the local property market.

Back to our example of setting objectives. For central banks, to extend the current economic cycle is challenging, but possible. To start a new, sustained phase of strong growth would be unrealistic, since central banks’ toolboxes are looking depleted. The implication is that risk assets could continue to perform well, such as Asian equities and emerging market fixed income, in the near term. In the longer run, taking a more defensive allocation in preparation for a downturn is still needed.

Tai Hui is chief market strategist for the Asia-Pacific at J.P. Morgan Asset Management

This article appeared in the South China Morning Post print edition as: Central banks face challenge to extend current economic cycle

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