After seven years in which major central banks differed only in their zeal for easier money and unconventional policies, monetary policies look set to diverge sharply.
The U.S. seems to be heading toward its first tightening move after seven years of zero rates, following comments by Federal Reserve chair Janet Yellen and a surprisingly strong October U.S. employment report, whereas Europe, Japan and China may need further monetary stimulus to revive their economies and counter deflationary pressures, analysts say.
“We believe that monetary policy divergence is coming,” says Michael Gapen, chief U.S. economist for Barclays in New York. “The U.S. and the U.K. have gradually separated themselves from other economies, but given the world business cycle, they can’t diverge all that quickly or robustly.”
The Federal Open Market Committee set the divergence train in motion on October 28, when it issued an expectedly hawkish statement that was upbeat on the economy and indicated that an interest rate hike would be up for consideration at its December meeting. Yellen reinforced that message in congressional testimony on November 4, saying a December rate hike was a “live possibility.” The employment data, which included a sharp 271,000 gain in nonfarm payrolls in October and an uptick in earnings, offered plenty of economic support for the Fed to tighten next month and sent the dollar rising sharply, while U.S. stocks and bonds sold off.
“The odds now favor a rate hike in December,” says Joel Naroff, an economist who heads Naroff Economic Advisors in Holland, Pennsylvania. “As long as we get a jobs number above 125,000 in November, the Fed will have what it needs to start normalizing rates.”
By contrast, the president of the European Central Bank, Mario Draghi, gave a downbeat assessment of the euro area’s economic outlook after the bank’s October 22 policy meeting and hinted strongly that the ECB would take action in December if things don’t improve. The euro area’s inflation rate fell to –0.1 percent in September, well below the central bank’s target of just below 2 percent, while the zone’s economy grew by 0.4 percent in the second quarter of 2015, down from 0.5 percent in the first.
“The risks to the euro area growth outlook remain on the downside,” Draghi said. The ECB is already buying €60 billion ($65 billion) a month of government bonds and has cut its deposit rate to a negative 20 basis points, but the president hinted that this was not enough, saying the ECB was studying “a whole menu of monetary policy instruments.”
“Central banks are trying everything they can, but they cannot really influence inflation right now, and that’s a problem,” says Carsten Brzeski, chief economist at ING Germany. “It’s a disinflation story, a stagnation, and there is no outward pressure coming from wages.”
Draghi’s comments helped push the euro to its lowest level in three months, and the U.S. employment report knocked it lower still. The euro was down by more than a cent on the day, at $1.0732 on November 6.
Europe is suffering from a lack of demand from emerging markets, particularly China, where economic growth has slowed sharply. On November 3 President Xi Jinping announced that the ruling Communist Party had set an annual growth target of just 6.5 percent for the next five-year plan, ending in 2020, down from this year’s 7 percent target. Highlighting concern about the growth outlook, the People’s Bank of China cut interest rates for the sixth time in a year in late October and lowered banks’ reserve requirements in an effort to spur lending.
“The worry is, if China is having a hard landing, what does that mean for everyone else?” says Barclays’s Gapen. “The old adage was, When the U.S. sneezes, the rest of the world catches a cold. Is that now true of China?”
China’s slowdown is hurting Japan as well. That country’s economic output declined in the second quarter, and the inflation rate fell to zero in the first half of the year. The Bank of Japan surprised analysts by failing to take any fresh easing measures at its October 30 meeting, but the central bank did downgrade its inflation forecast for this year, to just 0.1 percent, and pushed back its target date for achieving its 2 percent inflation objective by six months, to March 2017.
Analysts now believe that the BoJ may let lower energy prices filter through the economy before taking any steps to stimulate activity. “The BoJ is now more backward-looking, not preemptive, like in October last year,” economists at J.P. Morgan said in a note to clients.
Aside from the U.S., the U.K. is the one other bright spot among major economies. The country’s purchasing managers’ index rose sharply in October, and retail sales jumped by 1.9 percent from the previous month, bringing the year-on-year rise to a robust 6.5 percent. Yet inflation dipped into negative territory in September, and the central bank’s Monetary Policy Committee warned on November 5 that trouble in emerging markets was creating downside risks to growth and was likely to keep inflation below its 2 percent target for the next two years. The pound dropped sharply after the announcement, as market participants bet that the central bank would not be raising rates any time soon.
That leaves the Fed as the only likely candidate among major central banks for an early rate hike. The market consensus, which two weeks ago didn’t see the Fed hiking until March, now firmly favors a December move.
“We’ve indicated that conditions look like they could be right for an increase,” Chicago Federal Reserve Bank president Charles Evans told CNBC on Friday. “The real side of the economy is looking a lot better.”
Yet even if the Fed does move first, U.S. rate hikes are likely to occur at a slow pace, analysts say.
“What the Fed has tried to say, but nobody will listen, is, It’s not the first move that counts but the pathway from the first move that matters,” says Naroff. “Because rates have been so low for so long, they know they can’t behave typically in unwinding those rates. There is way too much risk.”
Joseph LaVorgna, chief U.S. economist for Deutsche Bank in New York, says he is worried by the fact that the U.S. is the only beacon of economic hope, which means the dollar is likely to rise substantially. “You could lose a substantial amount of GDP from net exports, which means lost income, and that’s a problem when the economy is only growing 2 percent a year,” LaVorgna says. “It’s like someone who has a weakened immune system. It doesn’t mean they are going to get sick, but they’re certainly more vulnerable than if they are really healthy.”
