Central Banks: contingent normalisation

Amid the further steps taken last week by the Fed and the PBOC to normalise policy and lean against improving economic and asset price momentum, a debate among investors continues to rage about how much global monetary policy is tightening and whether market pricing is appropriately calibrated to policymakers’ reaction functions.

Certainly, there is now a smaller gap between central banks’ implicit or explicit guidance about the likely future path of policy than was the case for most of 2016. For example, the two rate hikes more or less baked into the US OIS curve this year is in line with the median projection of FOMC members, though investors still appear sceptical of the Fed’s 3% terminal rate projections (see Chart 1). The Bank of England did not lift rates in March, but the meeting statement and minutes did appear to be an attempt to reduce market complacency about how long the bank rate would remain at 25 basis points if the MPC’s economic and inflation forecasts were realised. Meanwhile, ECB policy may be more or less on a set course through 2017, but that is not stopping market speculation about when and how they will seek to exit from their unconventional measures through 2018 given that those changes will need to be preannounced before the end of the year. Among the large central banks, only the Bank of Japan’s policy outlook seems stable, both because its own credibility is now so bound up with the yield targeting regime, but also because of the wide recognition that real rates must be kept low for many years if underlying inflation is ever to sustainably reach 2%.

It is of course natural for investors to fret about the future path of policy given the importance of the rate structure for the economy and the way that unconventional post-crisis policy measures have affected markets. Yet we still think the most important takeaway from recent central bank decisions is that policy remains state-contingent rather than on a set course. The Fed is adjusting policy because it continues to make progress towards its objectives. The BoE is sounding a bit more hawkish because the domestic economy continues to surprise in its resilience. The ECB is debating its exit strategy because the economy is growing above trend and it expects that to feed through to inflation over time. Indeed, this trend toward normality should be welcomed.

Jeremy Lawson – Chief Economist – Standard Life Investments