Despite all the research around central bank policy at the zero bound – specifically, that the forward guidance framework necessitates that the central bank promises to keep monetary policy easier than it would otherwise – central banks globally are failing at the implementation. The Fed, ECB, and BoE have all outlined economic “thresholds” that need to be crossed before hiking.* Those thresholds are all set at levels that suggest that each central banks’ reaction function hasn’t changed much.
There are several reasons why this is the case. The whole forward guidance concept (wrongly named, in my opinion) is a bold new step in Central Banking, so policy makers are likely wary of moving too quickly. And the effectiveness of central bank promises, as we are finding out in the US, is dependent upon consistent leadership. Finally, with respect to the US, the Fed may be concerned about the speed of the recent rise in housing prices. The Fed is likely sensitive to charges that it was responsible for the housing bubble, and with its macro-prudential mandate, The Fed’s tapering action may be an attempt at slowing the pace of appreciation, in addition to its concerns on the size of its balance sheet.
In conjunction with market technicals, I think this has pushed yields globally to levels that will likely to equate to a monetary stance that is too tight given the level of growth and inflation. Only time will tell whether this view is correct or not, but the crux of the matter is dependent on one’s view of whether developed economies have reached “escape velocity” or not. That is key, because without sufficient underlying growth momentum, this tightening of monetary conditions is likely to drive a slowdown next year.
*Let’s run through the unemployment thresholds:
Fed: The Fed thinks NAIRU is 5.5%-6%, and the neutral policy rate is 4%. In the last cycle, the Fed tightened at a pace of ~200bps a year. Well, if they start hiking at 6.5%, and it takes 2 years for unemployment to decline 1.5% (which is roughly the trend rate over the past few years) then at that NAIRU rate of 5.5%, Policy rates will be around 4%, which is their self-stated “neutral” rate. (I know consensus expectations for the Fed’s SEP to show 2016 policy rates of 2.25%, but that is also driven by the fact that the Fed thinks the low participation rate is cyclical)
ECB: no thresholds listed… they’re not even trying! But 5y Inflation forwards are at 1.5%, so if the market is right, they will be substantially undershooting their inflation target.
BoE: In the last cycle, they tightened at a rate of ~125bps a year. If they start tightening with UER at 7%, and UER continues to decline at a pace of ~0.5% a year, rates could be 6.0% once UER hits 5.0%. (The BoE seems to think NAIRU is ~5%. In the August Inflation Report, the BoE said this on page 30: “Evidence on job-finding rates and job creation suggests that the natural rate was just over 5% in the run-up to the 2008/09 recession. Since then, it is likely to have been broadly flat.” However, it also said that the “medium term equilibrium rate” could be around 6.5%)
- US Retail Sales rose 0.2% MoM in Aug vs 0.5% exp and 0.2% prev. The core measure rose 0.2% vs 0.3% exp and 0.5% prev
- UMichigan Confidence declined to 76.8 vs 82 exp and 82.1 prev
- Kuroda said Japanese economic growth will likely exceed forecasts even after a consumption tax hike; the country can still emerge from deflation despite the higher sales levy
- Mon: US Empire Mfg, Canada Existing Home Sales
- Tue: UK Inflation, German Zew, EU Trade Balance, US NAHB Survey, TIC flows
- Wed: BoE Minutes, Housing Starts, FOMC, Japan Trade Balance
- Thu: UK Retail Sales, Initial Jobless Claims, Philly Fed, Existing Home Sales
- Fri: RBI, Canada CPI