Global Themes - Monetary Policy Is Decoupling

  • Global monetary policy dynamics are likely to be mixed over the coming year, with continued tightening in the US likely to keep some of the more vulnerable emerging markets on the defensive. Deflation remains a serious global risk.

  • We expect the European Central Bank to remain in easing mode for some time to come, with options including additional interest rate cuts and other measures, so long as deflationary pressures remain. The US Federal Reserve is set to continue tapering in 2014 despite weather-related weakness in economic activity in December-January. We expect the Bank of Japan to maintain its current policy for the remainder of H114, but believe that once signs of economic weakness become clearer in H214, they will succumb to political pressure to further expand bond purchases.

  • Most central European central banks are likely to start hiking rates before the end of 2014. In Latin America, we expect tighter policy in Colombia, Mexico, and Brazil. Asian monetary policy will be mixed, with Chinese lending policy likely to be the dominant regional risk.

Although talk in recent years of economic decoupling has been largely unfounded (more of a decoupling of growth rather than cycles), decoupling of monetary policy is now an emerging trend. During the financial crisis central banks across the developed and emerging world simultaneously eased policy as credit markets seized up, with the subsequent spike in global inflation triggering a shift towards tighter policy (led by emerging markets, but also including the eurozone where the ECB increased the refinancing rate to ward off a perceived threat to price stability). Fast forward to today and the outlooks for monetary policy are diverging sharply.

The following two charts provide an indication of the easing/tightening bias at a global level. The first chart shows the number of economies (covering the 60 largest states) where monetary policy has been tightened or eased over the last three months. In most cases this is determined by changes in official policy rates, but for the US, eurozone, Japan and UK, our indicator also considers the impact of more unorthodox monetary policy measures that influence monetary conditions. The recent shift higher in the global tightening indicator can be attributed to passive monetary tightening at the ECB and the recent EM rate hikes.

Diverging Outlooks
Global - Proportion of Economies Experiencing Monetary Tightening/Easing
  • Global monetary policy dynamics are likely to be mixed over the coming year, with continued tightening in the US likely to keep some of the more vulnerable emerging markets on the defensive. Deflation remains a serious global risk.

  • We expect the European Central Bank to remain in easing mode for some time to come, with options including additional interest rate cuts and other measures, so long as deflationary pressures remain. The US Federal Reserve is set to continue tapering in 2014 despite weather-related weakness in economic activity in December-January. We expect the Bank of Japan to maintain its current policy for the remainder of H114, but believe that once signs of economic weakness become clearer in H214, they will succumb to political pressure to further expand bond purchases.

  • Most central European central banks are likely to start hiking rates before the end of 2014. In Latin America, we expect tighter policy in Colombia, Mexico, and Brazil. Asian monetary policy will be mixed, with Chinese lending policy likely to be the dominant regional risk.

Although talk in recent years of economic decoupling has been largely unfounded (more of a decoupling of growth rather than cycles), decoupling of monetary policy is now an emerging trend. During the financial crisis central banks across the developed and emerging world simultaneously eased policy as credit markets seized up, with the subsequent spike in global inflation triggering a shift towards tighter policy (led by emerging markets, but also including the eurozone where the ECB increased the refinancing rate to ward off a perceived threat to price stability). Fast forward to today and the outlooks for monetary policy are diverging sharply.

The following two charts provide an indication of the easing/tightening bias at a global level. The first chart shows the number of economies (covering the 60 largest states) where monetary policy has been tightened or eased over the last three months. In most cases this is determined by changes in official policy rates, but for the US, eurozone, Japan and UK, our indicator also considers the impact of more unorthodox monetary policy measures that influence monetary conditions. The recent shift higher in the global tightening indicator can be attributed to passive monetary tightening at the ECB and the recent EM rate hikes.

Diverging Outlooks
Global - Proportion of Economies Experiencing Monetary Tightening/Easing

The second chart looks specifically at emerging markets. In the instances where central banks have been adjusting policy, this is still predominantly in the direction of further easing. However, as we have mentioned above, there has been a recent surge in tightening among the more fragile emerging markets.

EM Central Banks Facing External Pressures
Global - Proportion of Emerging Markets Economies Experiencing Monetary Tightening/Easing

Within the developed world the divergence in monetary policy cycles is epitomised by the split between the eurozone and the US and UK. In the case of the eurozone, a lack of structural reform and cumbersome central bank policy has severely weakened the economy and set the bloc further back in the monetary policy cycle. Suboptimal economic rebalancing (underpinned by a collapse in periphery domestic demand rather than sharply improving economic competitiveness), financial fracturing in the form of falling cross-border asset holdings, and passive monetary tightening as a result of banks repaying LTRO funds, has further compounded the difficulty of engineering a single monetary policy and providing much-needed stimulus. In light of the severe economic challenges facing the bloc, we expect the European Central Bank (ECB) to remain in easing mode for some time to come, with options including additional interest rate cuts (culminating in a zero refinancing rate or a negative deposit rate), LTRO top-ups and credit easing.

Jumping The Gun?
Europe - Euribor & Short-Sterling Implied Policy Rates

In stark contrast, the UK is further along in both the economic and monetary policy cycle. A freewheeling central bank with the ability to engage in discretionary quantitative easing, coupled with progress made on deleveraging and structural economic reforms, has allowed the UK to pull away from the wider European malaise. Although we are still concerned about the sustainability of the economic recovery, growth is nonetheless strong and rate expectations are ramping up. If fixed investment takes off and real wages pick up then the recovery stands a good chance of hitting escape velocity - at which point the Bank of England can begin tightening policy without fear of derailing the economy.

In the US, Ben Bernanke's successor Janet Yellen has made a dovish impression in her first weeks at the helm of the Federal Reserve, with long-end bond yields sinking and rate expectations being pushed back further. But in our view the real driver of the pullback in interest rate hike expectations has been the disappointing economic data from December and January, which is forcing a reconsideration of the robust US growth acceleration that began in late 2013. Much of this is likely to be weather-related, with massive storms battering a large swathe of the country, and the biggest drought in California for over a century. The overall effect will not be known until data are released over the coming months, but in any case this is an additional headache for the Fed as it will be relying on increasingly erratic data as it assesses the need for further tapering. Still, we continue to expect the overall trajectory of data to be strong enough over the course of the year to warrant steady reductions of bond purchases, with the unemployment rate dropping to 6.2% by end-2014. Inflation will remain low, giving the Fed a bit more time to wait before raising rates (we see the funds rate rising only by late 2015).

Winter Weather Leads To Growth Disappointment
US - Fed Funds Future Implied Increase In Rates (pp) And US Economic Surprise Index

The Bank of Japan (BoJ) held its balance sheet target steady at its February meeting, and suggested that no further easing steps are on the horizon as they are content with the current trajectory of economic activity and inflation. The BoJ expanded its special lending facilities to the banking system by one year from their scheduled expiry in March (in line with expectations), but these measures essentially increase liquidity without injecting additional money directly into the economy. We expect the BoJ to maintain its current policy for the remainder of H114, but believe that once signs of economic weakness become clearer in H214, they will succumb to political pressure to further expand their bond purchases. Already the BoJ's bond purchases exceed these size of the country's fiscal deficit, but to prevent bond yields from rising as inflation pressures mount, we believe that more aggressive bond buying is on the horizon.

In the emerging world, monetary policy trajectories are also diverging. Given the broadly benign global inflation environment, the EM central banks that are shifting towards monetary tightening are doing so under duress. For the likes of Turkey, Brazil, India, Indonesia and South Africa, a lack of structural reform and unsustainable balance of payments dynamics are brushing up against improving DM economic conditions and Fed tapering. These central banks recently had to tighten policy in the face of mounting pressures on domestic currencies, despite economic growth being both weak and fragile. For the rest of the EM majors, policy is still broadly accommodating as central banks wrestle with weaker economic growth and anaemic international trade (the driving force behind many EM growth stories in recent decades).

Asia - External Fortunes Vary: By and large, the direction of monetary policy in Asia is likely to be neutral-to-easy. Most countries are relatively well-insulated from higher US yields, with one of our core views in the recent EM shake-out being that Asia does not face another 1997-style crisis, since fundamentals such as current account positions, reserve coverage, and short-term debt are in better shape. Among the more vulnerable countries externally are India and Indonesia, but even they have adjusted significantly following major currency sell-offs in 2013. We believe that Indonesian monetary authorities are likely to maintain a hawkish stance on monetary policy through H114, before assuming a more accommodative bias towards the latter stages of the year. In India, growth concerns will ultimately outweigh inflation worries for the Reserve Bank of India, and we maintain our outlook for the central bank to deliver 50bps worth of cuts in FY2014/15 (April-March), which will take the repurchase rate to 7.50% by the end of the fiscal year.

In China, despite rapid increases in credit growth in January (with a 109% m-o-m surge in new total social financing) we maintain that myriad headwinds continue to point towards a slower lending environment as we move further into 2014. While we expect the Banko Sentral ng Pilipinas to raise its benchmark interest rate only towards the latter half of the year, the scope for continuing accommodative monetary policy in the coming months has narrowed, as rising core inflation, increasing bond yields and a weak peso are pressuring policymakers to raise rates. As such, there is an outside chance of a rate hike as early as Q214. Bank Negara Malaysia will continue to maintain a neutral stance by keeping its policy rate on hold at 3.00% throughout 2014.

Given our expectations that upward pressures will be capped and downside pressures on the South Korean economy will begin to mount, we expect the Bank of Korea's monetary policy to remain fairly accommodative and do not envision any interest rate hikes through the rest of the year. We maintain that the Reserve Bank of Australia will return to its easing bias in H214 despite having held its key policy rate at an all-time low of 2.50% in its February 4 meeting. With an economic slowdown imminent, we maintain that the RBA will cut the cash rate by 50 basis points to 2.00% by end-2014. While the build-up in economic momentum in New Zealand presents upside risks to our forecast for just one 25bps rate hike 25bps (the market is currently pricing hikes of 75bps), we believe that the monetary authorities will remain cautions given the heightened volatility in the external environment and signs that house price growth in New Zealand is finally moderating.

Latin America - Divergent Monetary Policy Outlooks In 2014: While 2013 saw slowing inflation and looser monetary policy in several of the largest economies in Latin America, we forecast greater divergence in both price growth and central bank strategy this year. We expect stronger price growth in both Chile and Colombia, but expect looser policy to be the result in the first case and tighter policy to follow in the second. We believe Mexico and Peru will see average inflation rates hold relatively steady in 2014, but forecast the Mexican central bank to tighten policy amidst a backdrop of accelerating growth, while Peru will halt an easing cycle as growth stabilises. Following additional tightening in the months ahead, Brazil's central bank will begin to cut its benchmark Selic rate by year-end as inflation fears subside and it confronts a tepid growth picture. One theme from last year that we expect to continue will be sustained rapid price growth in Argentina and Venezuela.

Price Pressures Broadly On The Rise
Latin America - Consumer Price Growth, % chg y-o-y (Adjusted By Central Bank Inflation Target Bands)

Brazil will remain at the forefront of emerging market central banks tightening policy this year, and we have recently revised our short-term outlook for interest rates to account for a more significant tightening cycle. Still-elevated inflationary pressures, combined with recent rate hikes by the central banks of Turkey and South Africa amidst significant downside pressure on their exchange rates, underpins our view for further rate hikes in the coming months. We believe that the Banco Central do Brasil will hike rates by another 75 basis points (bps) to 11.25% in the next few months before pausing. However, our end-2014 interest rate forecast for Brazil remains below consensus at 10.75% (as compared to an average estimate of 10.88%), implying 50bps of cuts by the end of the year. This is underpinned by our view that monetary tightening will start to temper inflationary pressures, and still-weak economic activity will see the bank shift its focus from reining in inflation to stimulating growth.

Emerging Europe - Most Easing Cycles Have Run Their Course: Across Central Europe headline consumer price inflation remains well below central bank targets, but we do not believe the region faces imminent deflation. The recent collapse in prices is mainly a symptom of slumping supply-side pressures, which should aid rather than hinder the incipient economic recovery. This picture is reinforced by the divergence between headline and core inflation readings, with stronger core inflation suggesting that demand-side pressures are relatively robust.

Over the short term it is hard to divine what this means for rates. Our view is that most CE central banks have now come to the end of their easing cycles, and policymakers will wait for the base effects of last year's commodity price slump to run their course before deciding on further action. However, this view assumes that regional central banks not only recognise the supply-side nature of the recent price collapse, but that they are also sufficiently immune from calls for further stimulus (mainly coming from powerful export lobbies), neither of which is guaranteed.

Demand-Side Price Pressures Building
Emerging Europe - OECD Composite Leading Indicators

Looking beyond the very short term, leading indicators reinforce our view that the improvement in growth will continue over the course of the year (see chart), meaning that we hold to our forecast for most CE central banks to start hiking rates before the year is out. This puts us on the hawkish side of consensus for Poland and Hungary, although rates markets for both are generally in line with our expectations. As for Romania and the Czech Republic, we are broadly in line with consensus and at present see little value in local FX or rates markets.

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