Evidence continues to mount that the era of extraordinary central bank policy accommodation is at an end.
This comes as a growing number of monetary policymakers consider following the US Federal Reserve’s (FED) lead to ‘normalise’ policy settings.
However, there remains considerable disparity between the so-called hawks and doves – or perhaps more accurately, the hawkish-doves and the more cautious policymakers.
Prominent amongst the former are the Fed who are already raising rates and now also the Bank of Canada (BoC) who have taken the first tentative step. Then there is the Bank of England (BoE), which remains the most hawkish bank yet to raise rates, while definitely considering doing so.
The more dovish set are those that now see significantly diminished risks of further policy easing and are at least considering a potentially tighter stance in future. This group consists of the European Central Bank (ECB), Norges Bank, and Reserve Bank of New Zealand (RBNZ).
The Reserve Bank of Australia also seems, at this stage at least, to be content to be in this group. It has adopted a “glass half full” narrative with regard to the economy, but sees no justification to warrant a shift in tone.
And lastly the Bank of Japan, which is broadly expected to stay on its accommodative course.
Assisting central banks in this policy shift is arguably a somewhat softer view of their key policy mandate – that is inflation targeting. Very few central banks are hitting formal targets and inflation outlooks are not at all certain.
Instead, there is seemingly more attention being placed on managing the cycle. At this point, if growth is solid enough for the output gap to be narrowing and unemployment to drift towards full employment, then this is an environment that warrants an adjustment of ultra-accommodative policy.
The expectation of accelerating inflation towards central bank targets, with limited threat of deflation, is seemingly now enough to at least consider withdrawing some policy stimulus.
Current cyclical dynamics aside, in which the Phillips curve is either broken or shifted lower, there are also the medium to long-term disinflationary impacts of technological advances and automation to consider.
This may see global central banks becoming accustomed and attuned to inflation hovering around the lower ranges of their respective target bands – or in time could even see them consider lowering their targets outright.
A further concern is financial stability and the future risks that household debt accumulation may present. These risks are only exacerbated by having interest rates too low for too long – a mistake that has arguably been made before in the US.
It should also be noted that this coincidental rather than coordinated shift in monetary policy merely represents steps towards a gradual removal of what are ultra-accommodative policy settings.
It in no way represents moving convincingly towards settings that would be considered as contractionary policy, and slightly tighter policy settings are therefore unlikely to materially curb the gradual acceleration of inflation.
We would also assert that with potential growth rates in most developed economies lower now than before the global financial crisis, central banks will be feeling their way to what are clearly lower neutral policy rates for an extended period of time.
This mix of lower neutral policy rates, lower inflation and lower potential growth rates all support the notion that bond yields, rising gradually, will remain lower for longer. Consequently, the reflation thematic, although intact, will only gradually gather momentum.
Central Banks: Rising as one? Not quite
As noted above, it is the Fed that is clearly well out in front in reducing monetary policy stimulus.
Its stance was demonstrated again in June as the FOMC (Federal Open Market Committee) increased the Federal Funds Rate by 25bp. As a result, the target rate rose to 1.00-1.25 per cent, while the Committee noted that the “labor market has continued to strengthen and that economic activity has been rising moderately so far this year”.
Economists remain of the view that there will be one more rate hike this year, based on the data flow, particularly growth and solid labour market performance.
The improved growth will come despite what are now increasing concerns, from economists and the Fed alike, that the softer pace of inflation may persist.
Also expected is an increasing focus on communication around when the gradual reduction of the Fed’s balance sheet how and will take place.
Across the border the Bank of Canada (BoC) raised interest rates for the first time in seven years (September 2010) this month. The hike was in line with market expectations and saw the policy rate rise 25bp to 0.75 per cent, in what was described as a “removal of stimulus”. The move was driven by the BoC’s confidence in its outlook for “above potential growth” for at least the remainder of 2017 and into 2018.
Although equally it recognised the softness of inflation recently as it remains in the bottom of the target range. Yet this has been attributed to temporary factors and Governor Stephen Poloz noted that it takes 18 to 24 months for a monetary policy action to have its full effect on inflation.
Poloz added that central banks must “target future inflation by anticipating future deviations from target”. This view somewhat justifies the BoC’s removal of stimulus before reaching its target, but it also shows its confidence that inflation will continue to accelerate – a confidence that could be misplaced given the uncertainty of the outlook.
There was no strong commitment from the BoC for follow-up hike, suggesting it will be “guided by the incoming data”.
The move by the BoC is an interesting paradigm to examine policy in similar commodity-reliant economies that face almost identical conditions – Australia and New Zealand.
If either the RBA and/or RBNZ look to follow Canada’s example, rate hikes may be forthcoming earlier than markets currently expect – although for now that’s a big ‘If’.
There was only a passing reference to financial stability, the statement noting “financial system vulnerabilities” will also guide future policy.
But again, central bankers in Australia and New Zealand will be keenly examining the impact of Canada’s hike.
Not only on its booming property market, but, as the BoC statement notes, the economy may be “more sensitive to higher interest rates than in the past, given the accumulation of household debt. We will need to gauge carefully the effects of higher interest rates on the economy”.
Exactly the same can be said for household sectors in Australia and New Zealand.
Dr Alex Joiner is Chief Economist at IFM Investors. To read his full July Economic Update, click here.