The biggest risk to asset prices and the global economy would be if the biggest institutions reduce their monetary stimulus at the same time.
With the ongoing synchronized pick-up in global growth, systemically important central banks will likely be more willing and able in 2018 to start and, in one case continue, the normalization of monetary policy. But what is true for the central banking community as a whole is more nuanced when assessed at the level of individual institutions. Here is the outlook in ascending degrees of policy difficulty and, therefore, of the risks of policy mistakes.
The U.S. Federal Reserve is the most advanced in the policy-normalization process. It has stopped its unconventional program of security purchases, hiked rates four times and set out a plan for the gradual reduction of its balance sheet.
The Fed will likely enter 2018 with another hike under its belt and a bigger window to normalize owing to the tax measures making their way through Congress. As such, markets may need to revise upward their implicit pricing of Fed actions to be more consistent with the projection of two to three additional rate increases next year. And, within the context of the ongoing “beautiful normalization,” such revisions won’t necessarily need to be disruptive to either financial stability or economic growth.
A complexity facing the Fed is that, when it comes to yields on longer-dated bond maturities and the shape of the yield curve, the unconventional policies pursued by its peers elsewhere in the advanced world continue to be an important influence. There, the degree of policy difficulties is notably higher.
The Bank of Japan will face mounting pressure to lift its foot off the stimulus accelerator. In addition to having to think more seriously about moderating its asset purchase program, the bank will likely take steps next year to revise upward its yield target on 10-year rates (currently 0 percent); and it will need to sequence this carefully with a reduction in unconventional purchases. The ease with which this is implemented will depend in large part on whether Prime Minister Shinzo Abe’s stronger domestic political situation allows for the implementation of long-delayed structural reforms (what, in the Japanese context, has been called “the third arrow”).
The European Central Bank will try its utmost to stick to its recently announced plan of halving monthly purchases to 30 billion euros ($34 billion) until September — a prelude to ending the large-scale purchase program altogether before taking policy interest rates out of negative territory. But, judging from the minutes recently released by the ECB, members of the Governing Board are said to have differing opinions, and the bank could find itself in the tricky position of having to change its forward guidance by accelerating the phasing out of QE, especially if inflation were to pick up faster than currently anticipated.
As tricky as that is, particularly for a central bank that sets policy for 19 different member countries, the complexities could well be less than those facing the U.K.’s monetary stance.
With growth prospects having been revised downward and with the inflation rate remaining well above target, the Bank of England finds itself in an unwelcomed policy dilemma, particularly after having been forced to hike this year for the first time in about 10 years. Responding to the persistent inflation overshoot by hiking again risks deepening the economic slowdown. Delaying the hike and inflationary expectations could take an upward turn for the worse. And all this before it factors in the Brexit uncertainty.
Putting all this together, there is good news for the global economy: The world’s most powerful central bank — the Fed — faces the lowest relative degree of policy difficulty (and in the process, would be able to restore greater policy flexibility to counter the risk of possible growth and inflation shortfalls down the road). Another relatively bright spot is that the greatest complexity is faced by the least systemic within the group — the Bank of England. But this does not translate automatically into a clear path when it comes to the risk of what would, in scenario analyses, turn out to be a central bank policy mistake in 2018.
Rather than reflecting the prospects of individual institutions, the greatest monetary policy uncertainty facing the global economy is what would happen if all these central banks, along with the People’s Bank of China, were to decide to reduce their monetary stimulus at the same time. When it comes to central banks, this is the biggest source of risk to asset prices and the global economy, and it would call for high-frequency policy monitoring and close international consultations.
Frontpage September 9, 2019