If you’re the decision making person/committee of any central bank other than the Fed, you must be looking with at least some degree of envy at the set of circumstances confronting the US Federal Open Market Committee (FOMC).
Right now US GDP growth is stronger than its non-inflationary potential, the unemployment rate is below NAIRU (non-accelerating inflation rate of unemployment), forward-looking indicators suggest the labour market will tighten further, wages are trending higher and the annual rate of core inflation is at its highest level in a decade and trending up.
Furthermore, while the FOMC is not exactly sure where the neutral fed funds rate is in the post-GFC world, their best guess (2.9%) is still higher than the current rate (1.9%). The best strategy is therefore to continue to tighten until there’s a good reason to stop. Sounds a bit old normal in that respect.
At the same time the FOMC is continuing to unwind its massive asset purchase programme as quantitative easing has turned to quantitative tightening. The pace of balance sheet run off steps up to $50 billion per month from October.
Compare that with the set of circumstances prevailing in Japan. As in the US, growth is running ahead of potential and the output gap is closed. In fact the BoJ has done a great job on that front – the output gap is the most positive it has been in a decade reflected in a tight labour market with the unemployment rate at 2.4% and accelerating wage growth.
The prospects of a sustained lift in core inflation haven’t been this good in year, yet the annual change is sitting at 0.2% yoy and currently on a downward trajectory. That will have the BoJ worried that deflationary structural forces are continuing to dominate the cycle.
There was some speculation prior to the most recent BoJ meeting that they would alter their monetary policy stance. What we ended up with was in our view better described as tweaks to policy to make continued aggressive easing more sustainable into the future.
Things have got a bit (more) complicated in New Zealand too. The RBNZ has already been managing the issue of a rock star economy that has failed to deliver any meaningful uplift in core inflation, let alone anything remotely sustained-looking.
More recently the economy has shown classic signs of being capacity constrained. Growth has slowed and core inflation (sectoral factor model) has nudged higher. To complicate matters further business confidence is at its lowest point since the GFC. The causes and consequences of that have been subject of considerable debate recently.
The RBNZ responded to that set of circumstances with an August Monetary Policy Statement that was at the dovish end of expectations, pushing their projected hike in interest rates out to the back end of 2020. The Statement was more dovish still, repeating their May comment that “The direction of our next OCR move could be up or down.”
The dovish-ness was amplified in the alternative scenario section which showed the RBNZ delivering 50bp more in hikes compared to its central projections if inflation surprised to the upside, but 100bp of cuts if growth surprised to the downside.
We now find ourselves in the somewhat interesting situation of having lower growth forecasts than the RBNZ (though gap has closed), while our inflation forecasts are a touch higher.
We square that particular circle by the fact that we believe potential growth will also be lower. Remember it’s not the absolute level of growth that matter to the central bank, its growth relative to its non-inflationary potential. Central banks have limited capacity to influence potential growth.
That leaves us continuing to believe that the next move in interest rates is up in the latter part of next year. But the RBNZ will only hike once core inflation is sustainably over 2% and trending higher.
The risk to that view in both the short AND longer term is to the downside. If the bank does anything in the next six months it’s more likely to be an OCR cut in response to weaker than expected growth. If they haven’t needed to hike rates by late 2020, the risk moves back to the downside as the global and domestic growth cycles turn down.
It’s so much simpler at the Fed….
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