Mon, 03 Jul 2017 6:48 AM EST
The beginning of the financial crisis is now nearly ten years in the rear view mirror, but central banks keep on trucking at or near historic levels of easy policy. However, with the global economy improving and the threat of deflation subsiding, the CBs are crackling with chatter about downshifting from emergency accommodation. But as long as the conversation is still focused on what the central banks are providing, the improving economic fundamental will not get their due attention.
The Fed has taken the lead in moving rates off the zero bound and starting the discussion about shrinking a balance sheet that was quadrupled during the crisis. To varying degrees over the last year, other central banks have also been broadcasting that the era of ever higher stimulus is done. The delicate task ahead for the CBs is to tap the brakes on extraordinary accommodation gently enough to prevent the global economy from jackknifing in the middle of the process.
Today’s undulating political landscape, exemplified by the Brexit, could still throw up new and unexpected roadblocks that could change the course of monetary policy. But it appears that the convoy of monetary stimulus is rolling into its final destination, preparing to unload its accommodation and start the process of normalization.
Fed: “Over and Out”
The US economic recovery has been motoring ahead of most other major economies. Amid this improved economic footing the Fed‘s accommodative stance is starting to shift, even as the woman in the driver’s seat, Janet Yellen, will be out of office by February.
But a lot of policy changes are still expected to occur before Chair Yellen signs off from the CB. For now, the policy path seems to be locked in on a two step process later this year: a likely September announcement on the balance sheet reduction plan, and then a third rate hike predicted for December.
The public discussions of the balance sheet normalization process have showed a fairly collegial view at the Fed about the process. The consensus at the Fed is that it should start this year and that it should work via a roll off of maturing instruments, rather than actively selling holdings, so that the process can operate quietly in the “background.” This gradual process should work the $4.5 trillion balance sheet down over several years toward a new normalized level that is around half its current size. A recent NY Fed paper suggested this process might take until late 2021, at which point the balance sheet could be trimmed to some $2.8 trillion in bonds and a smattering of MBS.
Markets have taken all of this normalization talk without a hitch – a sign of general confidence in the Fed roadmap. Clear communication will be more important than ever to ensure that markets are not taken off guard by the unwinding process.Aside from the July 26 FOMC policy announcement (which has no scheduled press conference), Yellen will have a few other opportunities to broadcast her intentions. On July 12, she will appear before the House Financial Services Committee, and will convene with a Senate committee the next day. She might also use the annual Jackson Hole symposium (August 24-26) to give color on the balance sheet plan. The theme of this year’s symposium is "Fostering a Dynamic Global Economy."
The Trump circus in Washington may influence how Fed decisions play out. All year the Fed has been cautious about the D.C. agenda, with FOMC members deferring the addition of potential new fiscal policy measures into their monetary policy calculus. Fed officials have repeatedly cautioned that the timing and scope of fiscal policy is too uncertain to calculate yet.
It appears that level of caution was warranted as the legislative agenda of the Trump administration has been delayed by party infighting and harried by weekly revelations in the Russia probe, dashing the early promises of rapid fire reforms. The Senate healthcare bill is the latest item to hit a stumbling block. The bill, centered on a major tax cut, has found critics on the conservative and moderate sides of the Republican Party, causing party leaders to delay a vote by at least a week as they seek enough support for passage. GOP senators are between a rock and a hard place as the unpopular bill could hurt many working-class constituents, while they remain dead set on their longstanding promise to repeal Obamacare.
Currently the healthcare bill appears more likely to fail than to pass, which would leave another hole in the Trump agenda. It would also erode confidence in the potential for passage of the most important policy issue for the markets, namely tax reform, which stuck in first gear at the moment. The White House tried to kick off its tax reform campaign with a press conference in April, but the underwhelming one-page list of bullet points didn’t add any new information. Since then, the administration has rolled back expectations of a tax reform bill from this summer, and is now tentatively hoping to see legislation by the end of the year.
Therefore the earliest we may see the impacts of fiscal reform on the economy will be later in 2018. So far markets have taken the setbacks in stride, but it remains to be seen if additional delays in the Republican legislative agenda or deeper intrigues in the Russia case will be met with calm.
BOE: “Mayday, May Day”
The Bank of England was once only a step behind the Fed in considering removal of accommodation, but any action in that regard was sidetracked by the surprising affirmative Brexit vote last June. Now, a year later, the BOE is looking over the horizon at a path toward normalizing policy. Late last month, the BOE’s chief economist Haldane said that while rates are at an appropriate level for the moment, the bank needs to take a serious look at tightening policy. He suggested that it would be prudent to remove some of last year’s stimulus in second half of 2017.
That was not idle commentary, as the monetary policy committee (MPC) saw two more voters join a hawkish dissent at the June 8 meeting (Forbes, and now McCafferty and Saunders joining). That 5-3 vote to raise rates off of 0.25% demonstrates that the BOE is not far from a decision to follow the Fed down the off-ramp toward normalization.
Since that vote, BOE governor Carney has confirmed that the committee will debate issues around raising rates in coming months. He has stipulated that the decision on the central bank’sreadiness to raise rates depends on how much weaker consumption is offset by business investment, as well as and unit labor costs and the economy's reaction to Brexit. Carney also made it clear that if the MPC agrees to tighter rates, any change would be limited and gradual.
To an even greater extent than the Fed, the BOE will be boxed in by political events. Last month’s snap election meant to strengthen Prime Minister May’s grip on the wheel ahead of Brexit negotiations had the opposite effect. Thanks to a bungled campaign and perhaps some Brexit vote remorse (aka ‘Bremorse’), the Conservatives lost their outright majority and were forced into a dubious alliance with Northern Ireland’s DUP. Thus, PM May goes into the Brexit talks with a weaker hand than before. This could ultimately lead toward a “bad deal” or out of political desperation a “no deal” scenario, uncertainties which could roil markets. The PM’s days at the head of government may also be limited. There have already been some rumblings within the Conservative Party that May should be tossed to the curb after the embarrassing setback in the snap election. Though support has not coalesced around a clear successor yet, some political analysts believe May’s days at Number 10 Downing Street are numbered, speculating that she could be out within six months. The guessing game about UK leadership will add another layer of uncertainty to the already difficult and unprecedented Brexit process.
ECB: “Breaker, Breaker” The Brexit vote last year tested the resilience of the EU, raising concerns that the cornerstone of European cooperation could come undone. Since then, the populist movement in Europe has experienced some setbacks – most notably the defeat of Marine Le Pen in the French election – and economic data has improved. That has eased concerns about the EU unraveling. Now the ECB has turned a corner, breaking with a decade of dovish talk. In a late June speech ECB President Draghi essentially declared the threat of deflation dead. Draghi announced that the factors impacting inflation “are on the whole temporary and should not cause inflation to deviate from its trend over the medium term, so long as monetary policy continues to maintain the solid anchoring of inflation expectations.” This echo of the Fed’s language on “transitory” factors surrounding weak inflation was enough to send the euro to a six-month high against the dollar as markets took Draghi’s statement to mean he is ready to contemplate the end of the era of extreme accommodation. The immediate one percent move in the EUR/USD in reaction to what was a fairly subtle shift in language by Draghi leaves us with the question of how much are central banks at the mercy of the markets. The European version of the ‘taper tantrum’ could be the next traumatic event for the markets, as they anticipate an end to the ECB’s quantitative easing program in 2018. To that point, earlier this year Janus' Bill Gross switched on the hazard lights, warning that when the ECB starts to taper QE it may signal the end of the bull market. So we will have to watch for outsized moves in response to policy shifts. If the markets are still stimulus addicted then there could be some surprising volatility (and maybe even some opportunities to back up the truck). Even before Draghi’s more hawkish remarks, the early June ECB policy meeting was a blaring horn sounding a possible lane change in monetary policy. Based on data confirming stronger economic momentum, the ECB revised its policy stance with an eye toward the road to normalization. The key move was a revision in the description of the risks to growth, now seen as “broadly balanced” (revised from “tilted to the downside”). Still the ECB continues to provide extensive accommodation with the quantitative easing program set to continue at a €60 billion per month pace at least through December and interest rates remaining at the present level “well past” the end of QE. Geopolitics could sideswipe the ECB’s policy schemes as the G20 meeting in early July may put more stresses on old alliances. Chancellor Merkel, the host of the leaders’ summit (July 7-8), has tried to put a good face on the meeting after the frictions felt during President Trump’s last European trip which ended in the US withdrawing from the Paris climate accord. Russian President Putin will also be stalking the sidelines of the G20, meeting with other heads of state, no doubt looking to drive more wedges between NATO allies.
BOJ: “Keep on Trucking” Following the trend seen in most G7 nations lately, political uncertainty is taking a toll in Japan. Since assuming office in 2012, Prime Minister Abe has generally enjoyed strong poll numbers as he brought stability to a government that had seen nearly annual turnover in leadership for several years. His ambitious ‘three arrows’ plan for beating deflation and revitalizing the economy won him broad support from the electorate. But four years into the plan, core CPI readings are only just edging into positive territory and Q1 annualized GDP hit a three quarter low of only 1.0%. With the data still not validating ‘Abenomics’ the PM’s poll numbers have slipped. Approval ratings for the cabinet dropped by double digits in June, falling below 50% for the first time more than a year. If they continue to slip toward 40% – the low hit in the summer of 2015 amidst a currency devaluation and stock market swoon in neighboring China – it could send confidence in Japanese markets downhill as well. For its part the BOJ is still riding ‘hammer down’ on easy policy. In his latest commentary BOJ governor Kuroda noted there is still a “long way to go” before achieving the 2% inflation target, and that perhaps they are only half way there. The governor does claim progress, with the Japanese economy on firmer footing and the financial system still stable. Yet the slow headway on inflation confirms that strong easing remains warranted in Kuroda’s eyes. Indeed reports say that the BOJ is contemplating a cut in the inflation outlook at its next meeting (July 19). Even with Kuroda’s foot still firmly all the way down on the accelerator, the BOJ is reportedly feeling the pressure of all the CB chatter about normalization. A press report in early June said that the BOJ was looking at a recalibration of communications to acknowledge the increasing global discussion of reversing accommodation. Such a communication would reportedly entail a declaration the BOJ is conducting simulations about ending QE, but also to convey that it will not be on the policy agenda any time soon. This sort of monetary ‘double clutching’ will require skillful communication from the CB.