Taking their sweet time
23 January 2018
There is a feel good factor around much of the global economy. Forecasters have been rushing to upgrade growth expectations, with 2018 pencilled in to be the best year since 2011. However, expectations around monetary policy seem to have shifted less. While market interest rates have been rising, the pricing embedded in these still suggests relatively cautious adjustments in policy over coming years. Perhaps the best example might be the US where, in spite of strong growth and looming fiscal stimulus, markets are still only expecting a little more than three rate hikes over the next two years. In many other developed markets even less is priced. Should markets expect central banks to withdraw the punchbowl more quickly amid a cyclical upswing?
In the US the short answer seems to be yes. Indeed, we expect the Fed to deliver more than double the tightening currently priced over this period. However, this would still represent slow tightening compared to previous cycles. Indeed, there look to be good reasons for cautious expectations across economies. The first of these is inflation. The acceleration in global growth is only expected to feed slowly through to stronger underlying inflation in economies. The second relates to central bank reaction functions. Following years of disappointments in inflation (and growth) we do not expect central banks to rush for the exit from their policy accommodation. Instead, they are likely to want to see clear signs of a sustainable return of inflation to their respective targets. Third, the effects of policy tightening are likely to be greater than before the crisis. There are clear signs that neutral, or equilibrium policy rates, have been trending lower, while debt has been rising across the global economy. Finally, a range of central banks are in the process of adjusting their monetary policy stance through other instruments. The Fed has started to shrink its balance sheet, the ECB is expected to taper its asset purchases this year and the Bank of Japan will likely continue to buy fewer bonds under its Yield Curve Control framework. Overall, the combination of healthy growth and slow policy withdrawals provides a favourable backdrop for developed and emerging markets. However, we will need to watch for any signs that the foundations of this policy mix, particularly around inflation, are starting to fracture.