The beginning of the end of competitive easing?
The last week has seen a re-rating of global monetary policy expectations, particularly in Europe. The European Central Bank was less dovish than expected following its September meeting and the balanced interpretation of recent various FOMC member comments is that the Committee is keen to push on with the normalisation of interest rates, though they will remain cautious. Of the major developed central banks only the Bank of Japan continues to flag the possibility of further action along with the Bank of England in the wake of the Brexit referendum.
A number of things have led us to this point. Deflationary pressures at the headline inflation level are waning as commodity prices stabilise and, in some cases, start to nudge higher. Even in China, the ‘poster child’ for global deflationary forces, producer price deflation is abating. From a low of around -6.0% in late 2015, annual PPI inflation has risen to -0.8% in the year to August 2016. So still negative, but heading in the right direction.
At the same time, there is a growing acceptance we are at the point that in some cases monetary policy has done all it can to raise demand. Once you’re printing money and have negative interest rates, there’s not much left to do. So in cases like Europe where the strength of domestic demand remains insufficient to close a persistently large output gap and provide any meaningful and sustainable lift in core inflation, it is time for fiscal policy to fill the void.
In the US, growth is likely to only come in at a disappointing 1.5% this year, but with productivity trending at less than one percent per annum (and the most recent reading negative), growth is still running ahead of potential. That means spare capacity will continue to be absorbed. Remember for central banks it’s not the absolute level of growth that matters – it’s the level of absolute growth relative to potential growth and implications of that for the output gap.
So despite the low growth, the FOMC is right to signal that interest rates will rise again soon. Right now, the debate is whether the next move comes in September or December. Market pricing gives a 20% chance of a hike next week and 50% in December. Both are too low in our view, though we think the chance of a hike next week is still below 50%.
The reality is that the crisis is over and it is time for crisis monetary policy settings to end. As we have talked about many times before, the over-reliance on monetary policy to fix the world’s problems has led to an environment in which central banks have engaged in a process of competitive easing. Where output gaps are closed or nearly closed low growth is due to structural impediments (low productivity) which neither monetary policy, nor fiscal policy for that matter, can fix.
In those countries, like the US and eventually Europe, we are seeing the end of the problem of low growth and low inflation which is about to become the problem of low growth and high(er) inflation.
This recent recalibration of monetary policy expectations has, not unexpectedly, resulted in some wobbles in markets. Bond yields are higher, particularly in Europe. We expect yields will continue to move higher but will be kept in check by still accommodative monetary conditions and, in the US, the only gradual withdrawal of that accommodation. And while we expect no new stimulus from the ECB, they are still buying bonds in a programme that is not scheduled to end until March next year and that when the end comes, it will be tapered.
Equity markets are wobbling again after a period of strong returns and relative calm. While the wobble will likely have further to run, we see this as being more in the nature of a correction rather than anything more sinister. The reality is that while global growth is not great it’s not bad either, monetary conditions remain highly accommodative overall and valuations remain supportive, except perhaps here at home.
If we are indeed getting closer to the end of money printing in Europe and rate hikes in the US, that’s great news for the RBNZ. This should assist with lower trade-weighted NZD and reduced need for lower interest rates in New Zealand, though not yet enough to change our view that they will cut again in November. But there is an increasing likelihood that may prove to be the bottom of the cycle.
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