Are central banks behind the curve?
Concern about rising inflation and higher interest rates, particularly in the United States, has been the fundamental factor behind the current correction in equity markets and the return of volatility. Are markets right to be concerned, and are central banks behind the curve?
We see recent economic developments as simply the next phase of the business cycle. Admittedly, it’s been a long cycle with many twist and turns along the way. We economists have tended to be premature (impatient?) in announcing the arrival of the various stages of the cycle.
At times it has seemed to have played out in agonisingly slow motion. From a peak of 10% in October 2009, it took seven years and five months for the US unemployment rate to get back to 4.5%, a level consistent with most estimates of NAIRU (the non-accelerating inflation rate of unemployment).
Despite the longevity, the cycle is playing out much as the textbooks tell us it should. The Great Recession created a huge amount of spare capacity, as demand picked up that spare capacity was slowly absorbed, and as we get closer to full employment wages start to pick up and businesses turn to investment to resource the still-growing demand for their goods and services. The recovery in business investment contributes to a cyclical (though not structural) improvement in productivity which in turn helps contain increases in unit labour costs. Simple as that.
Right now, the US unemployment rate has spent nine months below NAIRU, broader measures of labour market slack (U6) are returning to more normal levels, and the annual rate of average hourly earnings has just ticked up to 2.9%.
At the same time, business investment is recovering nicely. Latest US GDP data had plant and equipment investment rising at an 11% annualised pace in the final quarter of 2017, with forward indicators suggesting stronger growth in 2018. A rising investment to GDP ratio can be considered ‘late cycle’, but we think there is ample room for investment to rise before it becomes anything close to signalling the imminent end of the cycle.
Productivity is difficult to get a handle on. It’s the ratio of two large numbers, output (GDP) and hours worked, the quality of the measurement of which, especially the former, are also open to conjecture. Nevertheless, US productivity growth seems to be settling at an annual rate of around 1% per annum, lower than where it has been in the past but likely to nudge higher if business investment continues to pick up. This is because installing or upgrading technology at a firm ideally lifts its hourly output per employee.
The bottom line is that, despite the longer time-frames, we are not seeing anything in the data to suggest we are diverging from anything other than normal. Neither do we think the Federal Reserve’s Open Market Committee (FOMC) is behind the curve. All we have seen so far is a tick higher in wages. While core inflation seems set to head higher this year, we are still yet to see that and we are a long way from seeing any sign that core inflation is heading significantly and, most importantly, sustainably above 2%. The FOMC would have to be convinced those conditions were more than likely to be met for them to aggressively step up the pace of tightening from the likely three or four hikes this year, or increase the magnitude of any of those individual hikes (from say 25 basis points (bps) to 50 bps).
The risks are certainly biased towards the Fed having to pick up the pace of tightening, especially given the impending fiscal impulse at a time when the economy is already at full employment and the output gap is effectively closed. But the risks are not all one way. There is a chance that productivity recovers more sharply than expected, suppressing unit labour costs and core inflation, thus allowing the FOMC to be more gradual than they currently expect. That’s not our base case though.
The US monetary policy cycle gets more interesting in 2019 as the FOMC gets closer to neutral. The guidance is still for another three hikes in 2019, but much will depend on whether 2.75% is really neutral. Only time will tell on that one.
While we see no reason for the FOMC to accelerate the withdrawal of monetary stimulus beyond their current guidance, neither do we see any need for the other major advanced economy central banks to become more aggressive either.
The European Central Bank’s (ECB’s) current asset purchase programme is scheduled to expire in September 2018. In that respect the ECB is just over three years behind the Fed, but they won’t have three years to get to where the Fed is now. In a world in which goods price inflation is picking up and global spare capacity is being absorbed, Europe won’t be immune. The asset purchase programme could get extended and tapered further in September, but it could also end early. Given the sequence of things the ECB still needs to do, interest rate increases are unlikely before 2019. But it’s here in Europe where there is the greatest risk of a hawkish surprise. Recent European Union political manoeuvrings have also raised the likelihood that Mario Draghi’s successor as President of the ECB from November 2019 will be selected from Germany, which would underscore a less dovish attitude, particularly regarding the scale and scope of bond purchases.
The Bank of Japan has dialled back its own bond purchase programme but the message from the Bank is that it remains fully committed to its current accommodative stance. And with the annual rate of core inflation currently sitting at 0.3%, we don’t see any change in that stance in the foreseeable future. And for both the ECB and the Bank of Japan the risk of exchange rate strength in the face of a hawkish turn will keep the path to normalisation gradual.
The Bank of Canada seems likely to continue to hike rates in the face of tightening capacity constraints. The Bank of England is the most interesting case right now as this is where uncertainty about the outlook (both economic and political) is greatest. Both will be cautious and gradual.
Right now, prudent central banks are doing exactly what we should expect of them. For markets that means getting used to the fact that the era of easy money is coming to an end, that net central bank asset purchases will be close to zero by the end of the year, and that the era of monetary policy divergence (the Fed versus the rest) is slowly turning to one of convergence. The historical aberration of negative interest rates prevailing in key economies to stave off deflation risk is likely to be gradually consigned to the economics textbooks.
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