“If All Goes According To Plan”: What Global Central Bank Normalization Would Look Like, In One Chart
AS a result of countless failures by central banks to normalize monetary policy over the past 7 years, the market – especially bonds and rates – has become openly cynical and outright skeptical regarding the possibility of a successful renormalization of policy by global central banks. After all, Japan has been trying to do that for over 30 years and has yet to succeed; the ECB hiked in 2011 resulting in near collapse of the Eurozone. Ironically, the recent Trumpflation trade – which few expected as a result of the “shocking” Trump election victory – has emerged as the most credible catalyst to prompt inflation not only in the US but around the globe, resulting in two Fed rate hikes in rapid succession.
Still, now that Obamacare repeal has failed, and questions are rising whether Trump will be able to implement his proposed Tax reform, the market has aggressively faded not only the broader Trumpflation trade, but also all of the recent dollar strength since the US election: in short, bets on a “bening” global reflation are rapidly fading, suggesting that the latest push to normalize monetary policy will once again result in failure.
And yet, “what if it goes according to plan” this time? That’s the question posed by Barclays’ Christian Keller who notes that, at least for the time being, “The synchronized upswing in the global economy continues, supporting sentiment, which thus far has ignored elevated policy uncertainties. Headline inflation is increasing due to stable oil prices, while core inflation rates are mixed.” And, assuming nothing ahcnes, this sets the backdrop for monetary policy normalization, albeit at different speeds and modes.
Taking this thought experiment one step further, what would happen if indeed this time central banks are successful to renormalize monetary policy without leading to a market crash. In that case, Barclays expects three Fed hikes in 2017 and 2018, respectively. The ECB is likely to taper further in 2018 and to start increasing depo rates in parallel (in 2018).
Conveniently, Barclays has created the following chart which lays out what “coordinated global renormalization” would look like. It can serve as a benchmark to those keeping tabs on where various central banks are in the current attempt to restore monetary normalcy.
For those curious, here are some further thoughts from Barclays:
Policy normallization at different speeds
With growth improving across regions and deflationary threats fading, the monetary policy cycle has started to turn. Market interest rates have been suggesting this for several months. Recently, central bank communication has also become decidedly more confident about the outlook. While the activity upswing is synchronized, the pace of expansion remains diverse and economies are at very different positions in the cycle. Thus, despite the signals are clearly for policy normalisation, we think such changes are likely to occur at quite different speeds.
Fed: A more confident FOMC leads the way
In contrast to 2015 and 2016, when economic developments at home and abroad thwarted the Fed’s plans for a four-hike pace in the coming year, 2017 has started out differently: the Fed now faces decent US growth, supported by buoyant sentiment, easier financial market conditions and no complications from ‘international developments’. This has given the FOMC more confidence to finally implement its game plan of a gradual hiking cycle; we now expect it to hike two more times in 2017 (Sep and Dec) and three times in 2018 at a pace of 25bp each time. A hike this June – not our baseline – would suggest a faster pace of four hikes per year, in our view.
Along with this firmer tightening cycle, we also expect the Fed to begin earnest discussions over when and in what manner to reduce the size of its balance sheet. Even so, we continue to believe that the Fed is far from taking any concrete action and we expect its balance sheet to remain substantively unchanged through at least the end of 2018.
ECB: complicated normalization ahead
Better growth and the rebound in inflation has significantly improved the balance of risks for the ECB by reducing the threat of a deflationary ‘Japan’ scenario for the euro area. However, the euro area is still far away from comfortable self-sustaining inflationary dynamics, and it still faces the looming risks associated with fragile public debt dynamics. The latter is particularly sensitive with regard to the euro area’s third largest economy and world’s third largest debt market, Italy, where there still appears a lack of political resolve for reform and uncertainty about the political outlook remains high. While this calls for caution, abovetarget headline inflation in Germany and the adverse effects of negative deposit rates on financial institutions are creating pressure on the ECB to start normalizing monetary policy.
In an attempt to balance these factors, we expect the ECB to implement a mixed strategy:
- We first expect in June (after the French presidential election) a change towards less dovish forward guidance that would open the door for deposit rate hikes in 2018, even before QE ends.
- We then expect a reduction in QE to EUR35-40bn per month in H1 18 and EUR15-20bn H2 18 as well as two 10bp hikes in the deposit rate in Q2 18 and Q4 18. We assign low probability to rate hikes in 2017 and PSPP purchases to stop in early 2018. In other words, we expect both QE and negative deposit rates to remain in place until at least H2 2018, even if at less-accommodative levels than in 2017.
This would clearly be a significant shift from earlier communication that suggested rate hikes would only follow once the asset purchase program had been terminated – which was the sequence the Fed and BoE used. Of course, neither the Fed nor BoE ventured into negative policy rates or had to implement QE across a diverse sovereign debt market. Such a multipronged exit strategy by the ECB would present a delicate communications act, as markets would have to decipher the net effects of a simultaneous tightening via deposit rate hikes and continuing expansion via asset purchases, even if at a reduced pace. Given the risk of adverse shocks (on inflation or debt dynamics) and memories of past episodes of premature tightening, we expect the ECB to move cautiously.
BoJ: ready to follow
The BoJ stood pat in March, as widely expected, and did not provide any hints of a future move or change in related communications. However, as the global environment remains supportive, we expect the BoJ to:
- raise its YCC target for long-term yields (+0%) by 10-20bp in Q3 17, assuming y/y core CPI inflation is accelerating at that stage, and
- hike a further 20bp each in Q1 18 (prior to the end of BoJ Governor Kuroda’s term in April 2018) and in Q3 18, due in part to a tailwind from expected continuing rate hikes by the Fed and, indeed, the start of an exit strategy by the ECB (hike in the deposit facility rate/reduction in asset purchases).
This will leave the BoJ in a reactive position as its yield-targeting policy since September has allowed it to ‘import’ passively the tightening in the US and other core markets. Overall, our inflation forecasts suggest that while the BoJ may have overcome deflation, the 2% target – which it promises to overshoot – is still not on the horizon.
BoE: still sitting on the fence
Surprisingly resilient data have made the BoE more confident about the economic outlook. March meeting minutes reported some members moving closer to supporting a hike, with MPC Forbes (outgoing in June) even voting for an immediate hike. However, we expect the rest of the MPC, in particular Governor Carney, to move more cautiously, waiting for data to crystallize before considering adjusting its monetary policy stance. Given our expectation for a slowing economy and only a temporary FX-driven boost in inflation, the MPC will most likely remain on hold over the forecast horizon, while markets have started to price some probability of a hike in 2018.
PBoC: Focused on stability
The PBoC continues to balance multiple objectives: supporting the growth target, while containing the build-up of financial vulnerabilities and the outflow of capital. Its recent increases of short- (OMOs) and medium-term (MLF) policy rates seem targeted to the latter goals and we expect the PBoC to follow up with more 10bp hikes in OMO and MLF rates in the coming months, especially if the domestic housing market continues to perform strongly and the Fed hikes rates further. At the same time, we expect it to leave the benchmark interest rates unchanged through 2017, to support growth, given that the bulk of China’s total financing is still dominated by bank lending (guided by the 1y benchmark lending rate). However, if CPI inflation developments look to exceed the 3% target and/or growth stayed above 6.5% q/q saar, the PBoC could consider benchmark rate hikes as well.
By using the shorter-term policy rates (10bp each time), rather than the traditional benchmark deposit and lending rates (usually 25bp each), the PBoC’s is attempting to achieve multiple objectives at the same time: guiding banks’ borrowing costs higher to promote financial deleveraging, while keeping benchmark rates unchanged to support growth: the bulk of China’s total financing is still dominated by bank lending (guided by the 1y benchmark lending rate at 4.35%), and the transmission from changes in the costs of the central banks’ liquidity instruments to banks’ lending rates will only be gradual. This strategy likely also serves the PBoC as an experiment, as it explores the transmission process of its various monetary tools with the objective to move its policy framework away from direct quantity-based measures to indirect price-based measures.