The shifting global monetary tides

 

Drew Klease, Principal Economist

The tide in global monetary policy has turned. Over the past few months, we have seen a raft of central banks begin to shift course. The US has been at the helm, lifting rates for the fourth time in June and starting its balance sheet reduction program in September. Canada has been next, surprising the market by raising rates in July and September. Last week, we saw the ECB announce a reduction in the pace of its asset purchases from €60 billion to €30 billion per month until September 2018. And this week, we have seen the Bank of England (BOE) raise rates by 25bps for the first time in a decade.  

Some common undercurrents have been behind all these decisions. The global economy is improving, with a synchronised recovery underway. Global trade and business confidence have moved higher and labour market conditions are tightening. Deflation risks have subsided and we’ve seen strong gains in risk asset prices. Fiscal policy has become far more supportive, allowing for monetary policy to ease up slightly. 

But there have been some notable differences between each central bank. In Europe, although momentum is strong, the ECB still needs to continue with asset purchases given the amount of slack across the region. Ongoing monetary policy support is also required to prevent a tightening in financial conditions via an appreciating exchange rate. In the UK, economic growth has been sluggish due to BREXIT-related uncertainties, but inflation has picked-up to 3% due to the lagged impact of the UK Pound’s post-referendum devaluation. The BOE has clearly become more worried about the high inflation rate, given the continued decline in the unemployment rate and the possibility that the weak growth reflects supply-side developments that monetary policy stimulus cannot fix.  

Looking ahead, the trend towards tighter monetary policy is likely to continue, although at a gradual pace. The announcement this week that Jerome ‘Jay’ Powell will replace Janet Yellen as Chair of the US Federal Reserve is unlikely to dramatically alter the Fed’s course. Powell is a current Governor of the Fed and is widely considered a centrist on policy issues; echoing comments by the Fed’s staff and sharing similar views to Yellen. This appointment by Trump will ensure continuity at the Fed and, as such, markets have taken the news in their stride. 

The prospect for additional fiscal stimulus in the US – with Republicans unveiling a package of US$1.5 trillion of tax cuts over the next decade – will also pressure the Fed to continue to gradually lift rates. While the package is likely to be amended further in Congress, we continue to expect the cost of the final package will be close to this amount. As such, we retain our view that the Fed will lift rates by 25bps in December, with a further three hikes next year.  

Elsewhere, we expect the move towards higher rates will be more circumspect. The BOE is now likely to remain on the sidelines for a considerable period as inflation eases and growth remains sluggish given uncertainty around BREXIT negotiations. However, we expect a 2-year transitional agreement will be reached early next year, with the resultant reduction in uncertainty allowing the BOE to follow-up with another hike in late 2018 and a further hike in late 2019. In Europe, growth is expected to remain above-trend next year, with inflation slowly edging higher. This will allow the ECB to taper and then cease its asset purchase program at the end of 2018, with rate hikes beginning around mid-2019. In Canada, an ongoing recovery will allow the BOC to lift rates twice next year, notwithstanding a slowdown in its housing market. 

Will Australia be caught up in these shifting global tides towards higher rates? In our view, the headwinds stemming from the housing market slowdown and the benign inflationary environment will cause the RBA to remain on-hold for at least another six months. Data released this week highlight these challenges, with retail sales volumes rising only 0.1% in the September quarter, a sharp slowdown from the surprise 1.5% gain seen in the June quarter, and national house prices flat in October (and down 0.5% in Sydney). However, over time, the improving global backdrop, a retracement in the Australian dollar into the low US$0.70s, ongoing solid public investment and strengthening non-mining business investment will support economic activity next year, despite the housing market headwinds. As such, we expect the RBA will be in position to begin to lift rates by 25bps in Q3 2018. Nonetheless, the highly-leveraged households will ensure a slow pace of hikes, with only one hike expected in 2018 and two hikes over the course of 2019. While all tides eventually turn, unlike the ocean, the timing around monetary policy tides are much more difficult to predict. 

 

Table 1: Financial market movements, 26 October – 3 November 2017

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,579.9

0.8%

US

2.35%

-11.6 bps

US Dollar Index (DXY)

94.69

0.1%

Nikkei 225

22,539.1

3.7%

Japan

0.06%

-1.5 bps

USD-JPY

114.08

0.1%

FTSE 100

7,555.3

0.9%

UK

1.26%

-12.4 bps

GBP-USD

1.306

-0.8%

DAX

13,440.9

2.3%

Germany

0.37%

-4.3 bps

EUR-USD

1.166

0.1%

S&P/ASX 200

5,931.7

0.3%

Australia

2.65%

-9.9 bps

AUD-USD

0.771

0.7%

Source: Bloomberg

 

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