A key theme for this year was the seemingly inevitable divergence in monetary policy among the key developed economies as the year progressed. In our outlook series at the start of the year we warned about not being overly swayed by the direction of headline inflation. This is because base effects were likely to see headline measures move higher as prior falls in commodity prices fell out of the annual calculation and were replaced by higher commodity prices.
Instead, and entirely appropriately, divergences in policy would be driven by divergences in the outlook for core inflation. In that vein, at the beginning of the year we expected continued policy normalisation in the US as inflationary pressures continued to build. At the same time, we expected a nudge higher in core inflation in both the Eurozone and Japan, but in both cases for it to remain below target and for both central banks to continue their respective asset purchase programmes. In the UK we expected monetary policy to remain on hold until the economic consequences of the Brexit referendum became more certain.
Time to review where things are at. Let’s start with Japan. GDP growth came in at an annualised 4% in the June quarter, its sixth consecutive quarter of positive growth. That’s the longest period of positive growth outcomes in ten years. More impressively, it was growth in domestic demand, particularly domestic consumption and business investment, that was behind the strong result.
But while economic growth has improved recently, core inflation remains stuck at zero, defying our expectations of a nudge higher this year, at least so far. The better growth suggests said nudge may still eventuate but in the meantime the Bank of Japan appears unlikely to change its stance of continued quantitative and qualitative easing (QQE).
Core inflation has nudged higher in the Eurozone in recent months, though at 1.2% is still well below target. But combined with recent better growth indicators, the European Central Bank (ECB) is expected to announce a dialling back of its asset purchase programme within the next few months.
In the minutes of the most recent meeting of the ECB’s Governing Council, the members indicated the need for “patience, persistence and prudence”. That doesn’t seem out of tune with the consensus market expectation of a halving of the current quantum of asset purchases from €60 billion per month to €30 billion per month from the start of 2018.
In the UK the recent inflation data seems to suggest the Monetary Policy Committee (MPC) could be justified in hiking interest rates. In fact, a couple of months ago they came very close with a vote narrowly avoiding a rate increase. That seemed to us to be the right call. While core inflation looks to be running hot, the reality is this is mostly due to post-Brexit currency weakness rather than a hot economy running up against capacity constraints. So while inflation may well head higher still over the next few months, the currency effect will start to wane and inflation will move back down again.
At the same time, the outlook for economic growth is unclear as Brexit uncertainty is yet to be fully reflected in business investment and economic activity generally. So despite nearly hiking in June, expect the MPC to be on hold for the rest of this year and most of next, though the risks of an earlier move are rising if growth proves stronger than we expect.
Despite earlier market expectations that the UK might be the next cab off the rank after the Fed at tightening monetary policy, that honour eventually befell the Bank of Canada (BoC). The BoC tightened by 0.25% in July, removing half of the 0.5% emergency cut in 2015 following the collapse in the oil price. Expect another hike in October (their September meeting occurs just before the Federal Open Market Committee (FOMC) meeting so it seems unlikely they will do anything then). Whether the BoC continues the monetary policy normalisation process after the emergency cut is completely unwound will depend on the outlook for core inflation at the time.
The most interesting case right now is the US. That’s where core inflation has looked to be most sustainably higher and is why the FOMC is furthest advanced in the normalisation of monetary policy. But we have now had five months on the trot of core inflation undershooting expectations and the ‘transitory weakness’ argument is starting to look a little over-cooked.
That said, there were signs in the most recent inflation data of some degree of stabilisation. Combined with recent solid activity data, particularly in the labour market, that will keep the FOMC on track for now. The consensus view is that it means an announcement on balance sheet normalisation in September. The consensus, at least among economists, is for a resumption of rate hikes in December, though markets are less convinced with futures pointing to a 30% probability of a December hike. I will take a closer look at the growth/inflation outlook in the US in my next post.
The implication for bond markets is that central banks are keen to get on with the normalisation process, but they will be cautious and the process will be gradual. Furthermore, while we expect bond yields to rise from current levels, they will remain low relative to history. This weekend’s annual symposium of the world’s central banks at Jackson Hole, Wyoming, would be a suitable forum for the bankers to signal the degree of urgency (or lack thereof) that they expect to bring to monetary normalisation in the months ahead.
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