Global Overview - Data dependent not reactive
When trawling through the communication materials from central bank meetings and speeches the term ‘data dependent’ features prominently. But as St Louis Fed President James Bullard pointed out in a 2016 note, data dependence does not mean that monetary policy decisions are based primarily on the near-term trends in the data. It also refers to more persistent trends in the data and the expectations for key macroeconomic variables over the forecast horizon. This broader and more nuanced definition explains why we are making few changes to our outlook for global monetary policy in the face of the recent moderation in growth momentum, protectionist turn in trade policy, and tightening in financial conditions. In the UK, we have pushed back the timing of when we expect the next rate increase to occur from May to August. But for the most part we expect central banks to view the moderation for what it is; a natural slowdown from the unsustainably strong growth recorded in the second half of last year amplified by weather and other temporary distortions. This is especially the case in the US where the impact of the large fiscal stimulus is still to be felt. And though the trajectory of trade policy is concerning, increased protectionism is still more of a micro than a macro story at this stage.
Context is also important when assessing changes in global financial conditions. There has been a tightening over recent months as market volatility, spreads in dollar funding markets and long-term interest rates have all risen. However, in aggregate the increases have been small so far, only modestly offsetting the loosening since early 2016 (see Chart 1), and leaving conditions still accommodative in most economies. Moreover, some of this tightening has been by design; keeping policy settings unchanged in response to diminished slack, reduced disinflationary risks and signs that growth is becoming more self-sustaining would be irresponsible. That said, we are monitoring economic and financial trends carefully. In economies where underlying inflation is still well below target (the Eurozone and Japan), or domestic activity is highly sensitive to US dollar liquidity (emerging markets like Turkey with large external funding requirements), policy will remain highly sensitive to any slower growth or further persistent tightening in conditions.
US - Unfazed
The Federal Open Market Committee (FOMC) will have a number of items to discuss at its meeting this week. Since its previous get together we have seen trade tensions continue to escalate, financial conditions tighten and GDP growth slow in the first quarter, at least according to initial estimates. At first glance this combination might be expected to create a degree of nervousness on the committee. However, we do not think that any concerns will be material enough to shift thinking or signals on the direction for policy. Indeed, the focus is set to remain firmly on withdrawing monetary accommodation, and we still expect the Fed to deliver seven more rate hikes between now and the end of 2019.
Part of this view stems from the still strong underlying fundamentals in the US economy, despite the now familiar disappointment at the start of the year (see Chart 2). While headline activity slowed we have still seen the labour market create jobs at a solid clip, business and consumer confidence remain generally upbeat and even productivity has shown signs of a long awaited revival. There seems to be little justification for the Fed shifting its view on the health of the economy after the recent stumble. On the trade front the recent news has been more worrying. The US followed up its action on aluminium and steel with threats to impose tariffs; first on $50bn of goods imports from China, followed by an additional $100bn should China retaliate. However, the impact of trade measures implemented thus far are still not large enough to have material effects on the macro economy and it is not yet clear that the full scale of trade measures between the US and China will be delivered. Moreover, tariffs weigh on the supply side of the economy as much as demand. In balance it is likely that the FOMC, like us, continues to look through the changes in trade policy, while warning about their long-term growth costs.
The tightening in financial conditions is grabbing a good deal of market attention. In particular the increase in the 10-year government bond yield last week above the psychologically important 3% mark, albeit briefly, has created concerns about the impact of rising rates on the economy. While the 10-year rate is naturally an important benchmark, it is important to look at broader financial conditions. These have also tightened over recent months, reflecting wider credit spreads and bumpy equity markets. However, again, this is unlikely to spook policy makers at this juncture. First, while financial conditions in aggregate have tightened, these are still not tight compared to even recent history (see Chart 3). Moreover, the Fed is likely to be comfortable with its policy settings becoming less accommodative at this stage. The economy looks close to full employment, with inflation not far from target, making the Fed less sensitive to market setbacks. Indeed, on this front the Fed will likely have watched the Employment Cost Index released last week with interest. While the headline rate was flattered by one-off bonus payments, underlying wages picked up to their strongest growth in a decade (2.7% year-on-year). Most importantly, the sharp loosening in fiscal policy risks overheating the economy at this late stage of the cycle. Fed policy will need to tighten more quickly to offset this impulse, with rate hikes expected once every quarter over the course of this year and next.
UK - What the Bank giveth…
Following a run of mixed data and unexpectedly dovish rhetoric from the Bank of England (BoE) Governor Mark Carney, we have revised our outlook for UK monetary policy. We now expect the Bank to increase interest rates by 25 basis points following the August Inflation Report, followed by a further two hikes in 2019. At 0.1% quarter-on-quarter, Q1 GDP growth was disappointing and well below the forecast of both the market and BoE (See chart 4). The Office for National Statistics (ONS) stated that the bad winter had a limited impact on activity, implying that the slowdown was genuine. However, this is hard to square with the softness of the construction and retail sectors, both of which are very sensitive to weather shocks. Construction was also probably hurt by the collapse of Carillion. These factors are likely to reverse in the quarters ahead, as pent-up demand is realised. The upshot is that our outlook for modest growth of around 1.5% this year is broadly unchanged.
In a recent speech, BoE policymaker Michael Saunders argued for ‘looking through’ temporary weakness in growth associated with weather effects. Moreover, the Bank is convinced the ONS systematically understates ‘true’ activity in its initial estimates of GDP. Both of these factors might suggest the Bank should look through this report. However, given heightened uncertainty about the outlook for the economy (given the difficult judgements the Bank is making about the impact of Brexit and the extent of economic slack), the Bank may be more sensitive to incoming data than would normally be the case. Moreover, inflation appears to be falling more quickly than expected as the currency depreciation effect fades. The combination of both growth and inflation undershooting the Bank’s forecasts force us to take Governor Carney’s recent comment that there are “other meetings” than May at which the Bank could hike rates extremely seriously.
Our view is that the core of the Monetary Policy Committee will want to monitor incoming data for several months before hiking to ensure that the slowdown is indeed temporary and that inflation is not falling too much faster than in its projections. We anticipate that by August the Bank will be in a position where it is comfortable to increase rates. Over a slightly longer horizon, the evolution of spare capacity and the transmission to inflation will determine the path for rates. We estimate that potential growth is much lower than it has been in the past and a little below our current forecasts. Unemployment has also fallen below the level the Bank thinks is consistent with full employment, while the employment rate is high by historical standards. Although the subdued trend in nominal wage growth points to some remaining slack, there is some evidence in the Bank’s Agent reports of a slight pick-up in wage growth. Moreover, public sector pay restraint is moderating, and minimum wages are rising faster than inflation. We therefore expect real wage growth to pick up through the year as nominal wage growth picks up further and inflation edges back towards target (see Chart 5). As a consequence, there is still a case for a limited and gradual tightening cycle as the erosion of spare capacity causes domestic price pressures to gently increase, substituting for the waning inflationary impulse of sterling’s depreciation.
Europe - Wake me up when July comes
That the European Central Bank’s (ECB’s) 26 April meeting was a holding operation was encapsulated perfectly by President Draghi’s comment at the press conference that the Governing Council “didn’t discuss monetary policy per se”. Instead, the opening statement and Q&A session focused on the slowing momentum in the Eurozone activity data through the first months of the year. The latest hard data on Eurozone industrial production, retail sales and trade have been disappointing, as has sentiment data for Germany, France and Italy. Draghi noted that the loss of momentum was broad-based across countries and sectors. But he also argued that this slowdown represented a natural moderation in growth momentum from unsustainably high levels in the second half of 2017, compounded by one-off drags from abnormally severe weather, the timing of Easter, and strikes in France and Germany. To this list we would add a bad flu season, particularly in Germany.
Signs that these weights on growth are temporary were evident in the stabilisation of PMIs and European Commission sentiment indicators in April (see Chart 6). The Q2 ECB Bank Lending Survey is also pointing to robust credit growth ahead. Overall, we agree with the ECB’s assessment that the Eurozone is still in “a solid and broad-based expansion”, though growth is probably past its peak. Admittedly, there are rising external risks to Eurozone growth, notably the increased threat of protectionism. A US-China trade war would impact the Eurozone largely through a negative confidence channel, rather than directly via the first-round effects of higher tariffs. But the ECB’s assessment (and our own) is that recent trade measures are more bark than bite. And a previous concern of the ECB – euro appreciation in excess of what would be justified by the strength of the economic recovery – has faded as the trade-weighted euro has stabilised. Overall, Eurozone financial conditions are marginally tighter than at the start of 2018, but don’t yet appear to be tight enough to be a significant threat to the outlook (see Chart 7).
Of course, the latest inflation figures remain modest, with headline HICP inflation at 1.3% in March, and core at 1.0%. Headline inflation should rise above 1.5% over the next few months, driven by the pass-through of higher oil prices. More fundamentally, Draghi noted “some evidence of strengthening nominal wage growth”, but “no convincing upward trend in underlying inflation”. Both we and the ECB expect continued economic strength and accommodative policy to drive an eventual convergence of inflation to target, but uncertainties about the degree of spare capacity mean that the monetary policy mantra remains “patience, prudence and persistence”. The ECB will publish new staff macroeconomic projections at its meeting on 14 June, but we expect it to wait until the 26 July meeting to announce a taper of its net asset purchases through Q4. Soon after, we would anticipate tweaks to the forward guidance on short-term policy rates, consistent with a first, 20 basis point, hike of the deposit rate around the middle of 2019. The current commitment to keep policy interest rates “at their present levels for an extended period of time, and well past the horizon of our net asset purchases” loses some of its influence on the broader interest rate complex once the horizon of net asset purchases is actually passed, and will have to be made more concrete.
Japan - Not ready to embrace change
Given last week’s Bank of Japan (BoJ) meeting was the first since the leadership reshuffle, all eyes were on potential changes to the policy outlook. But the BoJ kept policy unchanged, with no real sign of dissatisfaction with the status quo. Kuroda reiterated he does not intend to scale back the degree of easing by changing Yield Curve Control (YCC) or balance sheet expansion until the 2% inflation target has been met. We find this credible and do not expect normalisation over our forecast horizon. However, the risk of policy modification is rising, with the probability of YCC remaining unchanged now modestly lower.
What is the case for modification? Previously we highlighted three key policy costs: cost of implementation; cost to independence/risk of fiscal dominance; and the cost of exit. We think policy costs have risen in all three areas. However, given we have ruled out a normalisation of rates, we think it is only the cost of implementation that is material to policy decisions at this stage. The primary concerns here are whether accommodative monetary conditions have resulted in: 1) financial imbalances sufficient to cause a cyclical downturn; and 2) impaired financial intermediation. Last week’s, Financial System Report gave a clean bill of health to the financial system, with none of the 14 sub-components of the Bank’s heatmap pointing to overheating (see Chart 8). In terms of financial intermediation, Kuroda has recognised the concept of a ‘reversal rate’ - when weak profitability in core lending results in weak credit provision due to insufficient loss-absorbing capacity or excessive risk taking - to maintain profitability. However, identification of a reversal rate is complicated by structural headwinds driven by overcapacity in a shrinking market. We expect this issue to remain a live one but conditions are not sufficient to blow the Bank off course.
Balancing against the costs are the benefits of policy. The Bank can point to a sustained drop in real interest rates as evidence its policy is working. However, the issue has always been one of blocked transmission channels. What evidence is there that inflation fundamentals are improving? The rise in inflation expectations and the output gap has been modest, while core inflation measures remain lacklustre, with the Banks’ preferred core CPI measure still languishing at 0.5% year-on-year (see Chart 9). While the benefits are modest, we are less convinced that the marginal returns are diminishing. Rising neutral interest rates mean that policy stimulus will increase as structural reforms take effect. In addition, the wage setting behaviour is finally changing with the Shunto outcome improved. This comes despite a supply-side shock driven by higher participation rates and rising labour productivity. In addition, there has been an unhelpful legislative delay in ‘workstyle reforms’. We consider these a form of wage policy – with the government pushing a particularly inflationary increase in base pay. There is a significant risk to the BoJ’s view that current policy settings will be sufficient to push inflation towards its target. Firstly, the neutral interest rate may not rise sufficiently if the structural reform agenda stalls. Secondly, the supply-side shock may not prove a one-off, with demographic or technology changes allowing firms to continue to absorb labour costs. Finally, the labour market reforms may be further watered down if Abe is pushed out of office. In the event that these risks occur, we think the next move will be easing.
Emerging Markets - Monetary hall of mirrors
Did the cut to the reserve requirement ratio (RRR) – the amount of cash that that banks must hold as reserves - signify a change in the stance of Chinese monetary policy? On one hand the People’s Bank of China (PBOC) was quick to emphasise that it was primarily a technical adjustment and did not represent a change from its “neutral stance”, but others (and the market) seem to believe it signifies a pullback from the deleveraging campaign and the start of a medium- or long-term easing trend. So how to interpret this recent move? Monetary policy in China has never been easy to decipher as they use a combination of liquidity tools and less-transparent macro-prudential measures to impact domestic rates and credit flows. The former controls how much liquidity the PBOC is putting into the banking system, the latter controls how much credit is allowed to come out of the banking system. In this context we view the recent move as largely neutral in that it is consistent with the PBOC’s broader policy stance over the last year. But the dirty secret is that the PBOC has already been easing over the past year and this move merely represents a continuation of that policy direction.
More generally, monetary policy in China has become somewhat of a hall of mirrors since the regulatory crackdown began, making it harder to understand the overall policy stance. The decline in broad aggregate credit growth (Total social financing plus local government bonds plus ‘hidden credit’), despite survey data showing loan demand to be at its highest level since 2014, highlights this conundrum (see Chart 10). Further complicating the picture, borrowing costs, although up from 2016, are still relatively low (see Chart 11). Meanwhile, although the PBOC followed the Fed with hikes to policy rates last year; it also offset the effect of higher rates by injecting 1.6 trillion renminbi (RMB) into the banking system through its various lending facilities, equivalent to a 100 basis points cut in the RRR.
When assessing the stance of policy, it helps to distinguish between supply and demand factors. Generally, we assume that if credit demand (either weak or strong) is the main factor then credit flows and rates will move in the same direction. But if supply is the main factor, then credit and interest rates should move in opposite directions. Thus the current environment looks like a negative credit supply shock: credit growth is down despite surveys showing strong credit demand, however it differs from past instances of tight credit supply in that interest rates have barely budged upwards. The only explanation is that the PBOC is maintaining very loose liquidity policy to keep market rates stable and low to partially offset sharp tightening in credit flows due to tighter regulations from the CBRC, China’s banking regulator. The RRR cut is perfectly consistent with this policy mix. After injecting 3.6 trillion RMB over the past two years; the latest cut makes last year’s loosening of policy more permanent as it offsets the lending facility loans due to be paid back. As we have said before, the PBOC has showed flexibility offsetting regulatory tightening to prevent similar credit crunches seen during past tightening rounds. With the head of the banking regulator also serving as party chief at the PBOC, it’s likely that this fine tuning will continue.