Monetary Policy World Tour

Monetary Policy World Tour

Key Points:

  • The Fed is preparing the U.S. market for an interest rate increase; odds favor one increase by the end of the year—specifically, the December meeting.
  • Draghi and the ECB didn’t deliver on extending their asset purchase program but will if they have to.
  • The BOJ “stands ready to use every possible policy tool” if necessary to achieve their policy objectives—especially key as they shift their strategy.

Alpha can be found in any corner of the globe, but before capital can be put to work, the fundamentals must be taken into consideration. Nowadays, one of the biggest drivers of returns is central banks. Accordingly, below is what you need to know for each major central bank, from where they stand to what expectations are being priced in, as well as the effectiveness of their current policy as measured by economic activity and inflation.

The Federal Reserve – USA

As expected, The Federal Reserve left interest rates unchanged in their September meeting. Fed Chair Yellen did, however, hint strongly at one hike by the end of the year, but slowness in numerous indicators dashed those plans for the September period. Prior to the announcement, rate hike odds were at 18%. For the next meeting, November 2nd, the market has rate hike odds at 7.2%. For the last meeting of the year, December 14th, the market is giving a significant edge to a hike. There is a 64.3% chance the benchmark rate is upped to 50-75 bps, 30.8% chance of being unchanged, and a very slim chance of 4.8% to the 75-100 bps range.

Business fixed investment, inflation, and energy prices have kept a cap on inflation for the time being, allowing the Fed to keep their low interest rate policy going. While energy prices can be skewed as a positive indicator for the American consumer, the lack of business investments is pretty bearish. Below is a chart of gross private domestic investment for domestic businesses in billions from Federal Reserve Economic Data (FRED). The rebound since the great recession has been strong, but investments have seemed to taper off as the Fed suggests.


(Source: U.S. Bureau of Economic Analysis)

Interest rate bulls clung onto one phrase in particular from Chair Yellen: “The case for an increase in the federal funds rate has strengthened but [the Committee] decided, for the time being, to wait for further evidence.” U.S. interest rate bulls will just have to wait another month, likely two, for the benchmark to be upped.

Across the pond, the European Central Bank (ECB) was also unchanged and is waiting for more data before they pivot or persevere.

The European Central Bank – EU

In early September, the ECB pumped the brakes on their growth forecast but counterintuitively didn’t extend their near trillion-dollar bond buying program, a disappointment to markets. Despite expectations to do so, Draghi held steady, giving him another tool to call upon should economic indicators turn south, or as Draghi said, “beyond, if necessary” when referring to the non-standard monetary policy measure end date.

Downside risk from the referendum and continuing global economic and political uncertainty are forcing the ECB to stay accommodative. Future growth expectations for 2017 were taken down 10 bps due to a lack of forecasted foreign demand, in part because of Brexit. As borders become more defined, analysts are suggesting jobs might become more difficult to come by. Unemployment is hovering around 10%. Another key indicator, inflation, is estimated to be at only 0.2% according to Eurostat’s flash estimate. The ECB hopes to get inflation up to 1.2% for 2017 and 1.6% in 2018. Although this is a bit away from current levels, with interest rates near or below zero, the ECB will eventually spur inflation.

No interest rate levers were pulled lower to spur economic activity in the latest period despite the disappointing growth and inflation news. The ECB’s Main Refinancing Operations rate stood at zero. The deposit rate remained squarely in negative territory at -0.4%. Finally, the marginal lending rate was left at 0.25%.

These low interest rates have been enabling green shoots of economic growth to appear. The EU is no longer experiencing deflation, and positive money supply statistics are developing.  For example, the ECB recently published M3 growth of 5.1% in August vs. 4.9% in July. This annual growth rate saw a bump in credit to the private sector vs. the July update. Private sector credit contributed 10 more bps to the headline M3 number vs. the period prior. Similarly, lending to non-financial corporations stood at 1.9% growth in August, unchanged from the previous month, but overall heading in the right direction.

The next key date for ECB watchers is October 20th, the second to last meeting for calendar year 2016. Moving further east, the Bank of Japan decided to pivot as of their last meeting.

The Bank of Japan – Japan

The Bank of Japan (BOJ) is shifting its strategy in a big way, but is still aiming to be accommodative.

As opposed to targeting a monetary base number, the bank is now going to be targeting the yield curve through “Yield Curve Control”. In addition to targeting short term interest rates, the BOJ will now have an operating target for long term interest rates – the 10-year Japanese Government Bond. In a speech to business leaders in Osaka, Governor Kuroda explained that the bank will now also operate in this duration, seeking a level of “around zero percent”. Other maturities will be determined by the marketplace, displayed below from the BOJ.


(Source: Bloomberg)

In the same speech, Kuroda explained that QQE (qualitative and quantitative easing) was successful because Japan is no longer experiencing severe deflation. The new strategy will strengthen current easing programs and achieve 2% inflation sooner, according to The Bank.

Despite Kuroda’s speech, inflation on the price front has actually not been cooperating with the BOJ. The latest inflation rate was reported to be -0.60% for Japan. The last few months have proved to be unresponsive, with consistent negative readings since April 2016. Inflation has actually been trending down since May 2014.

Also of note was the shift away from the “two in two” verbiage. There is no longer a timeline for achieving 2% inflation other than “at the earliest possible time” according to Governor Kuroda. Giving the bank further room to work, Kuroda also indicated that they plan to overshoot their inflation goal. The BOJ is looking for 2% average inflation over a business cycle. For an economy in secular stagnation, this will be especially difficult, though the BOJ has proved to be creative in designing monetary policy.

The next BOJ policy meeting is on November 1st. Some economists are predicting the BOJ to bring their benchmark rate further into negative territory, which stands at negative 10 basis points for now.

Other Situations & Conclusion

In addition to the institutions mentioned above, there are certainly plenty of other major players to look into, from the Bank of England (BOE) to the Reserve Bank of Australia (RBA), both of which have unique situations they are dealing with. The BOE, for example, just released their quarterly bulletin where they outlined how the market and economy are digesting the results of the UK’s decision to leave the EU. The bank ended up cutting their Bank Rate (the interest rate the BOE charges institutions for overnight liquidity) 25 bps, announcing a term funding program (making sure interest rate cuts flow to consumers), and allowing the bank to purchase up to £10B in corporate bonds and an additional £60B of government bonds. The BOE also predicted the decision could cost the economy 250,000 jobs. BOE Governor Mark Carney reassured the country with these swift actions after the vote, but he is not the only central bank governor that is predicting tough times ahead.

Of the banking systems we looked into, the Federal Reserve is the only one managing interest rate expectations higher for tighter monetary policy. Other institutions like the BOE and BOJ are still trying to spur growth and inflation. Similarly, the RBA is also in the midst of trying to spur economic activity. Australia is experiencing “very subdued growth in labour costs and very low cost pressures elsewhere”, so inflation will remain low for the foreseeable future. The RBA is coming off of two rate cuts this year, with their cash rate at 1.5% currently.

Such global interest rate policies have brought up many questions, from speculation of another real estate bubble to perhaps the markets’ overreliance on low interest rates. UBS recently published a piece that called out a few geographies that are likely realizing a real estate bubble. London and Sydney were some of the cities at “bubble risk” in part due to their monetary policy. While asset prices have surely benefited, the real economy as measured by growth and inflation is not responding as much as it used to.

The laws of diminishing marginal returns on such measures need to be taken into consideration. The International Monetary Fund (IMF) Research department just recently said that the “effectiveness of monetary policy to tackle persistent disinflation may be diminishing in economies whose interest rates are close to zero”—a real consideration for geographies like Japan that have been especially aggressive.

Japan is an extreme case, but consistent disinflation is a risk. In this scenario, companies and households bring down their future expectations, postponing investments and hiring, leading to a deflationary spiral. Accordingly, it’s important for policy creators to bring up medium term inflation expectations to avoid deflationary spirals and a negative feedback loop.

The IMF study found that economies that are near the zero interest rate level don’t have as much ability to boost perception of medium term prospects, effectively getting trapped. In the same sense, central banks can’t afford to be stubborn and ignore underwhelming data. As of now, there isn’t a right or wrong answer to low interest rates. Accommodative monetary policies are here to stay for the majority of developed economies and investors should be aware.


Fariba Ronnasi
CEO, Elite Wealth Management

Full Disclosures:
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions in the companies mentioned through stocks, options or other securities.

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