Strategy & economics
Monetary policy sans frontières
The Federal Reserve (the Fed) pushed back an interest rate increase in its September meeting, citing concerns over heightened financial market volatility and uncertainty on global risks. In our view, assigning considerable weight to global risks complicates the Fed’s policy outlook. The Fed, at the centre of the monetary policy universe, has sent a confusing signal to everything that gravitates around it. Its inaction is likely to inject further uncertainty into global markets and potentially create a negative feedback loop.
Showing an unusual degree of concern over the potential impact on the US of events outside the country’s borders, the Fed referred to China and emerging markets (EM) as a key reason for leaving monetary policy on hold. This adds an unusual external dimension to the Fed’s traditional dual mandate of full employment and price stability. The Fed’s focus on the US labour market has become well understood and created some clarity with regard to the likely course of monetary policy. By including global developments in its checklist, it has added many more variables and unknown-unknowns to the decision-making process: the Fed has no control over developments in the Chinese economy or the price of oil. However, it has used both as excuses to delay a policy tightening, despite growing evidence from the domestic economy that a rate rise is long overdue.
The strongest argument in favour of policy normalisation remains the sharp improvement in the US labour market. The unemployment rate has fallen to just 5.1% which is only a touch above the neutral rate, below which inflation pressure will mount. Job openings have surpassed their pre-crisis high, backed by strong hiring intention from small and medium-sized businesses. It does not need an economist to conclude that as the labour market tightens, wages will increase and domestic prices will face upward pressure.
Those who believe that leaving interest rates at near-zero is justified point to headline inflation, measured by the consumer price index (CPI), which is at zero. However, this largely reflects the slump in energy prices and once this effect washes out of the annual calculation in early 2016, CPI inflation will likely flip up to 2%. Already, there is evidence that rising pressure on services and housing prices is offsetting the impact of falling goods prices. Indeed, in the most recent reading of the ‘core’ CPI (which excludes food and energy products), inflation ticked up from +1.8% to +1.9%.
In the world of monetary policy sans frontières, the Bank of England (BoE), the European Central Bank (ECB) and the Bank of Japan (BoJ) are also being forced to make allowance for international developments when setting policy. Compared to the situation in the US, there is an even stronger case in the UK to normalise policy as it is showing more obvious wage growth. This reflects rising pressure in the labour market resulting from a record high employment rate (the highest amongst G7 economies). The latest BoE Agent Survey shows “over half of business respondents reported that recruitment difficulties were constraining workforce growth”. Recruitment problems also contributed to “rising wage pressure in the services sector”. Masked by the -0.1% headline CPI, services sector inflation is running at +2.4%. So, with growth still running above the long-term sustainable rate, there is a strong case to raise rates. Whether the BoE will prove brave enough to do this ahead of the Fed remains to be seen (but we doubt it).
While international developments are delaying tightening in the US and the UK, whose economies are in the later stage of the growth cycle, there is growing pressure on the ECB and the BoJ to step up their quantitative easing (QE) programmes. Should they or shouldn’t they? Eurozone money supply data shows credit growth to the corporate sector is improving thanks to loosening credit standards. The improvement in economic activity is broadening, new car registrations are averaging 10% growth year-on-year and retail sales are expanding at the fastest pace in 10 years. While we think it may not be necessary for the ECB to undertake further stimulus when activity in the eurozone is gathering pace, it could easily find itself backed into a corner by financial markets – as has happened previously. In the latest ECB meeting, Mr. Draghi sent a very dovish signal and hence set a very high expectation for further easing measures in December. Even if the ECB were to ease further, we doubt that there would be significant benefit to the eurozone economy. As Albert Einstein once said “insanity is doing the same thing over and over again and expecting different results”. The eurozone and Japan should instead focus on domestic structural reforms to boost productivity and wage growth.
With economic activity showing good momentum, leaving monetary policy too loose for too long will add to, not reduce, economic risk. As labour markets tighten, there is a growing probability that inflationary pressure in the UK and US will increase more than currently anticipated. Because monetary policy works with a long lag, delaying the tightening may eventually result in central banks having to move more aggressively than would otherwise have been the case. Furthermore, should our economies hit a bump in the road, monetary policy will prove ineffective as further cuts in interest rates are likely to have minimal impact (or could even prove counterproductive).The assumption seems to be that additional ‘unconventional measures’ – quantitative easing – could be initiated, but with the system already awash with liquidity, this is likely to be of little help. Leaving interest rates at abnormally low levels also prolongs the price distortions evident in some asset markets – most obviously government bonds. We remain concerned that delaying policy moves until they become absolutely necessary will result in significant loss of liquidity in bond markets when interest rates do finally rise.
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