The central banks of the United States, Europe, and Japan are at, or close to, policy inflection points. In the United States, we see core inflation close to target levels, but elsewhere, we think that sustained inflationary pressure is unlikely.
The U.S. Fed is in hiking mode
The Fed hiked in December 2016 and generated a flurry of excitement when there was some movement in the “dot plot” mapping Federal Open Market Committee members’ expectations for future rates. A more careful assessment of the summary forecasts, the press conference, and the meeting minutes suggests to us that the Fed is, like us, waiting for more clarity on the fiscal policy outlook. Moreover, it is clear that the Fed is feeling more confident that the economy is continuing to use up excess supplies of labor.
If the economy continues on its current course — that is, notwithstanding any Trump-induced fiscal boost — then we would expect to see a couple of interest-rate hikes in 2017. If substantial fiscal measures are enacted, and if corporate animal spirits push up capital expenditures, then we think the Fed would feel the need to respond more aggressively. That said, the upward pressure on the dollar that we would expect from such a policy trajectory would probably perform much of the Fed’s work for it.
If the economy continues on its current course, we would expect to see a couple of interest-rate hikes in 2017. If substantial fiscal measures are enacted, we think the Fed would feel the need to respond more aggressively.
If we see a surge in price pressures from protectionist measures, or a border tax, the Fed will likely react by hiking more aggressively, although, again, the Fed would end up being constrained by dollar strength. Nonetheless, it is important to note that the Fed is in a hiking cycle now — or at least it thinks it is — and the Fed is conveying that message to the market.
The complicated world of the ECB
At its December meeting, the European Central Bank (ECB) announced that quantitative easing (QE) would be extended from March 2017 to at least the end of the calendar year, but at a reduced monthly pace. This provoked a long discussion among market observers about whether this was “tapering” or not. The big issue here is whether we should think about QE in stock or in flow terms. Is it the size of the central bank’s balance sheet that matters or the flow of central bank purchases into the market? The ECB wants to argue that its balance sheet will continue to expand, and that it will be larger in December 2017 than it would have been otherwise. But many analysts said the drop in the monthly pace of purchases sent the more important message.
Academics and central bankers have pretty much reached the conclusion that it is the stock of QE that matters, not the monthly flow. Market participants are more likely to think it is the flow that matters, since that provides the daily demand in the market. We think the ECB thought it was sending a dovish message, saying it was continuing to keep easy monetary policy at a time when the Fed was sending a different message. The ECB, in other words, wanted to drive home the theme of policy divergence. But the reduction in the pace of QE sent the message to the markets that the end was in sight.
The ECB has another problem — inflation
Headline inflation, driven by energy market developments and the drop in the euro, has moved significantly higher in the eurozone. Indeed, a few German banks have been muttering about the target being in sight. German CPI was 1.7% in December, which prompted the same people to declare that German inflation has reached its target.
Our inflation forecast sees core inflation in the eurozone edging up in the second half of 2017, but broadly stable throughout 2018 and well below the ECB’s target. We also see headline inflation drifting down through 2018. However, our forecast also sees these developments occur only after inflation rises rapidly and higher than 2.0% twice in 2017. And therein lies the ECB’s problem. It needs to keep policy easy to support the ongoing economic recovery and raise core inflation, but it faces political pressure that will come as headline inflation rises.
This is not to say that actual policy rates will rise any time soon. We expect rate divergence will continue. But the ability of the ECB to control monetary conditions, especially in the periphery, may be challenged. These risks are most serious in Italy.
The ECB needs to keep policy easy to support the ongoing economic recovery and raise core inflation, but it faces political pressure that will come as headline inflation rises.
Beyond Abenomics at the BoJ
The BoJ’s yield curve control policy, which aims to keep the 10-year Japan government bond (JGB) yield close to zero, was certainly tested by the sharp rise in Treasury yields after Donald Trump’s election. Then, in mid-December 2016, when the 10-year JGB flirted with a yield of 10 basis points, there was some serious talk in Tokyo about a possible BoJ response and about the dangers of such a response. In the event, the BoJ’s resolve was not tested, and JGB yields drifted back down.
Importantly, the yield curve control policy gives freedom to fiscal policy and the government is beginning to take advantage of this. Japan is thus inching ever closer to using helicopter money. Moreover, the drop in the yen since Trump’s election makes the BoJ’s inflation target look more plausible. For the time being, therefore, the combination of a weaker yen, the yield curve control policy, and the fiscal expansion makes the BoJ the most dovish of the major central banks.