The outlook for global central bank policy

August 22, 2017 11:56
The market currently forecasts only a roughly 40 percent probability that the Federal Reserve will raise rates for the third time this year. Photo: Bloomberg

Since the end of 2009 and the conclusion to the global financial crisis, the world’s three major central banks – the US Federal Reserve, the Bank of Japan and the European Central Bank – have collectively grown their balance sheets by approximately US$9.8 trillion and counting, with a significant proportion of this extra liquidity finding its way into financial markets.

Valuations across most major asset classes have inflated in a highly correlated fashion as quantitative easing plans have helped to suppress volatility and drive down risk-free rates.

Given the extent to which central bank policymakers find themselves in uncharted territory, what can we expect by way of policy action over coming months? How would this set of actions compare to current market expectations? And how might these policy actions impact financial markets and asset prices?

After the Fed's two rate hikes so far this year (four since the start of this rate hike cycle), the market currently forecasts only a roughly 40 percent probability of a third rate hike by the end of 2017, and then the equivalent of only 20 basis points of rate hikes in 2018 versus the Fed’s "Dot Plot" of median Fed official expectations for three rate hikes next year.

Clearly the recent moderation in global inflation has led the market to remain deeply skeptical of the case for many further rate hikes.

Moreover, Fed chair Janet Yellen’s recent assertion that we are not that far away now from a neutral level of real interest rates has affirmed a certain level of complacency.

However, there is some element of truth in the Fed’s view that recent disinflation headwinds from mobile phone service pricing and prescription drug prices will eventually moderate, even if new headwinds in the form of new and used auto selling prices are emerging.

Furthermore, leading economic indicators, notably the pace of real narrow money growth, have accelerated in the United States in the last four months and, with a recently weakened US dollar, there are signs that a firming of consumer price inflation and economic growth in the US could happen from the end of 2017 onwards.

This could force the Fed to accelerate the pace of its rate hike cycle again.

As such, a third rate hike in December 2017 is a possibility, but a lot will depend on how financial markets absorb and cope with the start of the Fed’s balance sheet tapering plan, which they have signaled will commence "relatively soon".

If this passes off smoothly, then rate hike number three could happen before the end of 2017.

However, if balance sheet tapering disrupts financial markets, then the Fed will delay that third rate hike, but likely not indefinitely.

Critically, what the Fed needs to do is to get its signaling and communication strategy right – to set the market up so it will not be surprised when it comes.

Secondly, it needs to be gradual in order to avoid another "taper tantrum". The FOMC minutes and discussions from the June and July 2017 meetings did just that, alluding to an initial US$10 billion of MBS and Treasury principals that mature not being reinvested and allowed to roll off each month.

Yet, it is not just the Fed that will be potentially tightening policy in coming months. It is anticipated that the ECB will also announce the next tapering step in its bond purchase program at its September 2017 meeting, having already cut monthly purchases from 80 billion euros to 60 billion euros earlier this year.

While plans can be well articulated, financial market responses are often unanticipated. A synchronized withdrawal of liquidity from financial markets by more than one major central bank is a noteworthy scenario.

Given the tight correlation between global financial market liquidity injections and asset valuations in the years since the global financial crisis, any reversal in that trend, even if well signaled and gradual, will inevitably present the single biggest challenge to the eight-year bull market in global equities that market participants have enjoyed.

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Portfolio Manager at Conning Asia Pacific