Behind What Central Banks Will Do This Week
The central bank policy meetings this week will confirm the absolute and relative degrees of difficulty facing three systemically important institutions -- from the somewhat straightforward for the Federal Reserve to the more complex for the European Central Bank and the devilishly complicated for the Bank of England.
The Fed’s policy announcement on Wednesday will include a 25 basis-point interest rate hike, the reaffirmation of the previously announced plan for reducing the size of the balance sheet, an updated summary of Open Market Committee members’ economic projections and confirmation of their forward-looking guidance for rate increases next year.
None of this should come as a surprise to markets, which will limit any durable impact on asset prices. Indeed, what is likely to be of greater interest is the tone, as well as the specific content, of the policy deliberations on two issues: the persistently sluggish inflation dynamics and the potential impact of the tax plan that is making its way through Congress. There will also be interest in determining how far foreign central banks and liability-driven investment (LDI) flows have contributed to the sharp flattening of the U.S. yield curve. Although Chair Janet Yellen may offer some insights in her press conference, the last one of her successful tenure, many more could be gained from the subsequent release of the minutes in three weeks.
The course is more complicated for the ECB. Having provided forward guidance on the tapering of its large-scale program of security purchases known as quantitative easing -- a prelude to lifting rates out of negative territory and an action that, according to media reports, has already triggered a range of opinions within the Governing Council -- the ECB now has to deal with three realities:
- Recent data that suggest the region’s economic recovery continues to strengthen and that it is reassuringly broad.
- Continued loose financial conditions that encourage significant risk-taking.
- And, related to this, increasing concerns about financial stability down the road.
Had this information been available a few weeks ago, the ECB’s Governing Council might have taken a less dovish posture when it comes to defining both the period of QE extension (until September) and the monthly amount (30 billion euros). While it is unlikely that these will be changed at this meeting, especially given the emphasis that central bankers rightly place on the importance of maintaining the credibility of “forward guidance” as an instrument of monetary policy, there could be posturing within the Governing Council to increase the probability of changes early next year.
Then there is the Bank of England. The meeting of its Monetary Policy Committee takes place the week that, once again, inflation surprised on the upside. And with the November reading coming in at an annual rate of 3.1 percent, Governor Mark Carney is now required to send a letter to the chancellor of the Exchequer explaining why inflation has overshot its target by so much.
One of the difficulties for the Bank of England is that the inflation overshoot is occurring as many forecasts, both domestic and external (including the one by of the International Monetary Fund), have revised down the U.K.’s growth prospects. As I argued last week, these stagflationary tendencies place the BOE in a particularly tough policy position: If it hikes rates, it risks accentuating the less positive growth outlook. If it leaves rates unchanged, it may see inflationary expectations take a turn for the worse. And all of this is in the context of a still uncertain outlook for Brexit (though it is somewhat less worrisome after the recent agreement with the European Union on the “divorce settlement”).
After hiking rates at its last meeting on November, the BOE will likely keep an unchanged policy stance for now. But this status quo would be concealing a tricky set of deliberations, in an environment in which the risk of a policy mistake is uncomfortably high. And that risk is unlikely to diminish any time soon.
There is an international topic that is unlikely to be discussed much this week, yet potentially presents the biggest risk to the global economy from the central banking community, including the Bank of Japan and the People’s Bank of China.
With the improvement in the outlook for global growth -- which involves the world’s four major economic areas (China, the euro zone, Japan and the U.S.) -- and with somewhat better prospects for a more comprehensive pro-growth policy response, especially in the U.S., central banks face mounting internal and external pressures to start or accelerate the normalization of their unconventional monetary policy stance. How and when each decides to do so will be guided predominantly by domestic considerations. Yet, the net result for the global economy will also be a function of the cumulative aggregation of these institutions’ actions, as well as their interactions.
Fortunately, this community has developed the means for the closest cross-border consultations among all economic policy-making entities (including fiscal and trade), especially under the auspices and convening power of the Bank for International Settlements (sometimes called the central bank of central banks). These institutions will need to smartly share insights if the world economy is to avoid a big risk to a welcome, but still tentative, improvement in its ability to deliver higher, more durable and more inclusive prosperity.
To contact the editor responsible for this story:
Max Berley at email@example.com