Towards monetary policy normalisation

Article #510 by Edward Rizzo - Published Weekly

In recent months, there were widespread indications that three of the world’s major central banks, the Federal Reserve, the European Central Bank and the Bank of England, will move towards monetary policy normalisation and gradually reduce the ultra-loose monetary policy conditions that have dominated financial markets almost for a decade now since the onset of the international financial crisis.

Last week’s monetary policy meeting of the European Central Bank (“the ECB”) was one of the key events that had been widely anticipated in this respect since the ECB was due to guide the market on its quantitative easing programme going forward since the current pace of monthly purchases of €60 billion was due to end in December 2017.

As predicted by most financial commentators, the ECB announced that it would scale back again monetary stimulus by reducing its bond buying programme (which commenced in early 2015) from the current monthly figure of €60 billion to €30 billion as from the start of 2018 and this level will be maintained at least until September 2018.

ECB President Mr Mario Draghi also announced that the QE programme will not stop suddenly, thereby suggesting that another extension, even if only gradually to wind down purchases further, is likely to be announced during the course of 2018. Mr Draghi insisted that further quantitative easing is required in order to reach the ECB’s inflation target of below but close to 2%. In fact, inflation is likely to remain below this level in the coming two years as the current indications from the ECB are that inflation will decrease from the present level of 1.5% to 1.2% in 2018 before rising back to 1.5% in 2019.

Moreover, the ECB reiterated its forward guidance on interest rates by stating that interest rates will remain at their present levels until after the end of its asset purchase programme. In essence, this implies that interest rates in the eurozone are likely to stay on hold until at least March 2019.

The ECB left interest rates unchanged at 0% and its deposit rate (the rate for banks parking money with the ECB) at -0.4%.

Mr Draghi also remarked that “if the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation”, then the QE programme may be increased once again “in terms of size and/or duration”.

Many international economists commented that this was only the continuation of a very gentle exit process from the QE programme as the ECB President also highlighted that “this is not tapering.. it is just a downsize”.

The term “tapering” has been used across international financial markets to describe the exit of a monetary stimulus programme.

Some critics, including the president of the German Bundesbank and the head of the Dutch central bank, have been suggesting that the ECB should end its bond buying programme due to the evident strength of the eurozone economy. However, Mr Draghi explained that although the eurozone economy was recovering, it still needed further support. He stated that “domestic price pressures are still muted overall and the economic outlook and the path of inflation remain conditional on continued support from monetary policy…. therefore an ample degree of monetary stimulus remains necessary”.

The message by the ECB President seems very clear and the ECB is possibly acting cautiously so as not to repeat the same mistakes of 2008 and 2011 when it raised interest rates, which it then needed to reverse on both occasions. The first u-turn came after the collapse of the US investment bank Lehman Brothers in 2008 followed by the region’s sovereign debt crisis in 2011.

Meanwhile, in the US, the process of monetary policy normalisation is at a much more advanced stage. Indeed, after hiking the target federal funds rate for the first time in seven years to a range of between 0.25% and 0.5% on 17 December 2015, the Federal Reserve subsequently effected three other interest rate increases of 25 basis points each. The first was done on 15 December 2016 whilst the other two additional interest rate hikes took place earlier this year - on 16 March and 15 June 2017. Accordingly, the target federal funds rate now stands at a range of between 1% and 1.25%. Nonetheless, various financial analysts and economists are largely expecting another rate hike of 25 basis points in December 2017 (to a target federal funds rate range of between 1.25% and 1.5%) whilst the Federal Reserve has also indicated during the last monetary policy meeting held between 19 and 20 September that it is on course of making yet another three more interest rate increases next year.

Although some financial analysts and commentators maintain that the Federal Reserve is being too aggressive in its monetary policy tightening in view of persistently low inflation, the target federal funds rate range of between 1% and 1.25% is still way below the target rate of 5.25% prior to the start of the international financial crisis almost 10 years ago when the first symptoms of the subprime mortgage crisis started to emerge in the US. Although it is true that current and expected inflationary pressures in the world’s largest economy are relatively soft by historical standards, the current annual rate of inflation of 2.2% is still the highest since 2012. Meanwhile, on more than one occasion this year, the chairperson of the Federal Reserve Janet Yellen opined that the current forces underpinning low inflation are largely transitionary and that inflation should pick up speed in the coming months. In particular, Ms Yellen believes that the current unemployment rate of 4.2% (which is the lowest in seventeen years) should eventually reflect in higher wage growth and afterwards into higher inflation.

Monetary policy normalisation in the US is not only limited to interest rate hikes. As from October 2017, the Federal Reserve started to gradually reduce the size of its sizeable holdings of Treasury and agency securities. Following the 2008 global financial crisis and the ensuing recession, the Federal Reserve rolled-out three rounds of quantitative easing programmes, the latest of which came to a complete halt in October 2014. In this respect, although the downsizing of the balance sheet size is yet another sign of monetary policy normalisation, the Federal Reserve has already indicated that the pace of reduction of its holdings of Treasury and agency securities will be very gradual and sensitive to market conditions.

In the UK, the Bank of England (“BoE”) is also widely expected to raise interest rates during today’s monetary policy meeting. As such, should the BoE raise its bank rate by 25 basis points to 0.5%, it would only be a reversal of the “emergency” bank rate cut announced on 4 August 2016 following the surprise outcome of the Brexit referendum. Furthermore, the BoE seems committed towards maintaining its expanded quantitative easing programme running, especially in current circumstances since its decisions are not only shaped by the more important economic indicators (such as inflation, GDP growth, and unemployment) but are largely overshadowed by the broader developments related to Brexit. In the meantime, it is also noteworthy to highlight that inflation in Britain is currently running at 3%, effectively making the UK the only G7 country where inflation exceeds the central bank’s target.

Monetary policy developments have wide ranging implications on various asset classes. In fact, in the immediate aftermath of last week’s ECB meeting, the euro weakened against the US Dollar, bond prices increased (as eurozone yields tumbled back) and equity markets continued to rally with the German and French stock market indices rising to fresh record levels. There could be greater monetary policy divergence between the US and the eurozone over the course of 2018 should the Federal Reserve, especially under a new chairperson, proceed with further interest rate hikes in 2018. Moreover, against this backdrop and coupled with a major tax reform expected in the US, the US Dollar may therefore continue to recover from the decline seen earlier this year. As was widely evident over recent years, statements by the major central banks can lead to periods of volatility across various asset classes and therefore investors should continue to be prepared for uncertain times.

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