When will central banks tighten monetary policy? This is a key issue for financial markets across the globe.
In recent months, markets have been driven by a combination of factors: health, political, economic data and policy. We were reminded by the US Federal Reserve (the Fed) over the last week in the minutes from its Federal Open Market Committee (FOMC) meeting that health continues to have a significant impact as, “The path of the economy continues to depend on the course of the pandemic.”
In fact, health and geopolitics still have the ability to trigger extreme outcomes, both for the global economy and for financial markets. Hence, developments on both the pandemic and geopolitics need to be followed closely. The latter, in particular, relates to Taiwan, and US-China relations. Notwithstanding this, it is economic data and policy that remains the main driver for markets.
Recent focus has been on monetary policy
Over the last week the focus has been very much on monetary policy, following policy meetings at the US Fed and Bank of England (BOE). Before looking at each of these, it is worth considering the broader picture of global monetary policy.
Monetary policy remains accommodative across much of the globe, even though many central banks are either in the early stages of implementing their exit strategy or are laying down the marker for it. In this context, exit refers to moving away from cheap money policies that have involved exceptionally low interest rates or central bank buying of assets such as government bonds.
However, as was the case after the 2008 global financial crisis, exit strategies will not be uniform, with the timing and approach varying across central banks.
Domestic factors will be the key driver, as evidenced by the fact that there are two major central banks that show little inclination to tighten policy. These are the People’s Bank of China, which having adopted a “prudent” monetary policy for some time, may ease policy again through various means such as lowering reserve requirement ratios to boost lending to contend with a slowing economy. Another is the Bank of Japan, which shows no sign of shifting from its easy money policy of recent decades.
Elsewhere, the European Central Bank (ECB), too, looks likely to not move for some time. This is despite evidence of gradual economic recovery. Perhaps it still chastened by its premature tightening in the wake of the global financial crisis, which triggered a subsequent sovereign debt crisis. Also, its head, Christine Lagarde has not been able to communicate well with financial markets. The ECB displays no indication it will hike.
Meanwhile, there are a number of central banks that have tightened, including some in large economies, such as the Bank of Korea or in Mexico, or sometimes influential ones, such as New Zealand or Norway.
What then about the Fed and the BOE? The issue is when to tighten and how.
The Fed’s actions
In my view the Fed has got this right, and the Bank of England has got it wrong. The Fed has signalled clearly its intentions. These have been interpreted as credible and thus the Fed has retained its integrity, bringing the market with it. Naturally, the Fed will be guided by the data.
The Fed has been clear that its exit strategy will be via tapering of asset purchases, as opposed to exiting via higher rates. That makes sense and it was a message that it provided further clarity on this week. The Fed stated that, “indicators of economic activity and employment have continued to strengthen” but that “overall financial conditions remain accommodative.”
As before, it reiterated that it wants to see more evidence of employment gains and that it will tolerate higher inflation for a short while, consistent with its aim of average inflation of two per cent.
This week it talked of reducing its asset purchases, although they will still remain sizeable. Net asset purchases are to be reduced this month, by $10 billion to $70 billion for US Treasuries and by $5 billion to $35 billion of agency mortgage-backed securities. Further reductions will follow, outlined in advance.
The Fed is therefore signalling a gradual and predictable exit that will not spook the markets, while policy rates stay low and unchanged, thus not derailing the economic recovery. Recent US data has been mixed – although the Fed was keen to point out to the strength of activity there has been a recent deceleration, not helped by uncertainty linked to the virus, rising energy costs and supply bottlenecks.
Thus, the Fed’s message is that higher rates will come later, with much debate still over when that will be. Members of the FOMC indicated when they see rates rising – with half saying hikes will begin next year, the others later. Along with Powell’s comments this provides the market with steady guidance.
The BOE’s approach
In contrast, the Bank of England’s signalling has been poor, and its outlined exit strategy, in my view, has been the wrong one, namely to not end quantitative easing (QE) earlier and to then exit via higher rates.
In recent weeks the market had factored in higher rates, largely in part because of hawkish comments from the Governor and the new Chief Economist. For instance, Governor Bailey in a speech to fellow G30 central bankers on 16th October stated, “That’s why we, at the Bank of England, have signalled, and this is another such signal, that we will have to act.”
Their comments, and by not correcting how the market or the media interpreted them, led to hawkish expectations ahead of the latest meeting that was not merited by the recent data.
This data led us to conclude that a rate hike was by no means certain at the recent policy meeting and so it proved. The data included a recent deceleration in US economic activity, a growth recession in China where growth is positive but has slowed significantly, higher oil prices and the expectation of an imminent squeeze on disposable income in the UK as inflation, energy prices and (next spring) taxes rise.
The Bank’s Monetary Policy Committee (MPC) voted 7-2 to keep rates at 0.1%, 9-0 to retain corporate bond purchases at £20 billion and 6-3 for gilt purchases to reach £875 billion. QE ends next month in the UK. In my view, QE should have halted some time ago. It is not just monetary stability in terms of rising inflation that is an issue, but financial stability, too. Low rates and QE are feeding financial instability, as we have outlined before. Once we move into the new year the focus will switch even more to policy rates.
Were it not for the inappropriate signalling from the Governor, the market would not have expected any tightening this month, sticking with its previous view that the MPC would, at the earliest, hike in February. Their next meetings are in December and February, and they are not expected to change policy outside of their formal meetings.
The Bank’s poor signalling has triggered self-induced volatility in both interest rates and in sterling. Their current messaging is that they will exit by hiking, and that when rates reach 0.5% they will let their holdings of gilts mature, and will not reinvest the proceeds. When rates reach 1.5% they will sell gilts on the open market.
In their Monetary Policy Report that accompanied their policy decision, the Bank indicated that they expect inflation to be higher than previously thought, reaching 5% in the spring. Also, the Bank stated interest rates will need to rise “modestly to return inflation to our 2% target.” But even then they see inflation being above target for some time. Energy costs play an important role; we think oil prices could rise further.
In terms of economic growth, the Bank now sees growth in the final quarter of each year of 6.7% (in 2021), 2.9% (2022), 1.1% (2023) and only 0.9% in 2024. As it said, “UK GDP is expected to be lower than in August throughout the forecast period, reflecting lower supply, higher energy prices and a higher market implied path for Bank Rate.”
There still needs to be a clear exit strategy for the MPC. Interest rates of 0.1% are too low, at emergency levels, but the economy did not, or does not, need an ending and reversal of QE and higher rates at the same time. The MPC’s signalling, timing and sequencing has been all wrong.
Having seen the Bank miss their opportunity to scale back QE over the last year the markets have now scaled back their view of when the Bank will tighten via higher interest rates.
Either the Bank shocks the market again or, perhaps more likely, they will react and follow the lead of the market which will be driven by the economic data. At the press conference after the meeting, attention was focused on developments in the labour market post furlough, wage developments and on inflation expectations.
The economic data and prospect of a cost-of-living rise contributed to the MPC keeping rates unchanged. On this basis it is by no means clear that the MPC will hike in December or February and that policy rates look set to stay low and rise gradually.
Please note, the value of your investments can go down as well as up.