Central bank watcher: Playing the waiting game

While the Federal Reserve and the European Central Bank (ECB) are adopting a wait-and-see stance, the People’s Bank of China (PBoC) is evolving its rate-easing cycle at a snail’s pace. Meanwhile, the Bank of Japan (BoJ) so far has managed to drag its feet on actual easing.

Looking ahead, our base case is for the Fed, ECB and BoJ to remain on hold in the coming 3-6 months, on the assumption that the global business cycle shows further signs of stabilization. Risks to our base case remain tilted to the downside, with additional easing still looking much more likely than tightening.

In bond markets, the bounce in yields may still have somewhat further to go. But given the asymmetric downside cyclical risks and secular trends, we would fade this.

Included in Fed chair Powell’s remarks during the press conference of the 11 December FOMC meeting was the statement that it will take a “significant and persistent” move up in inflation for the Fed to hike rates. He distinguished the recent Fed easing from the 1998 episode, when cuts were quickly followed by hikes.

The US economy is starting to show end-of-cycle characteristics. Corporate profits are on a declining trajectory, momentum in labor market data is slowing and households as well as corporates are much more optimistic on current conditions than on the future outlook. Even after a Phase One trade deal with China, trade and political risk will not go away, especially with US presidential elections being on the agenda. Equally important is the message from the Fed that the bar to hike rates is high, because of their desire to lift and solidify inflation expectations.

The bar for cutting rates is also quite elevated. A “material reassessment” of economic conditions would be required, as Powell has indicated. But when push comes to shove we do not think the Fed would want to risk much, if any, further slowdown of the economy. Our base case is for the US economy to stay on this gradual slowdown track. Our central scenario for the Fed fits this template. Our main alternative scenario is for a quicker slowdown and fiercer monetary easing.

Although some leading indicators suggest the downturn in Eurozone economic growth may be bottoming out, the pace of growth remains slow and fragile, as the preliminary November PMI surveys reminded us. Moreover, underlying Eurozone inflation still lingers at around 1%, well below the ECB’s current medium-term inflation target of “below but close to 2%”. It was thus no surprise to hear the new ECB President Christine Lagarde stressing the need for a prolonged phase of highly accommodative monetary policy, while underlining that the ECB stands “ready to adjust all of its instruments, as appropriate” – hence retaining an easing bias.

The pace of policy rate easing has remained much more sluggish than that of many other central banks. This is because Chinese authorities seem to have a higher tolerance for slower economic growth than in the past, given the focus on deleveraging and de-risking of their financial system.

Nevertheless, given the lingering downside risks to the growth outlook, subdued core CPI inflation (1.4% in November), and the risk of a renewed flare-up in the US-China trade conflict – even if a phase-one deal is indeed agreed – we continue to expect further easing steps from the PBoC. This includes a cut in banks’ reserve requirements.

We remain of the view that the BoJ is firmly on hold, despite the marked deterioration in the economy and inflation outlook that was triggered by the VAT hike and natural disasters this quarter.

We believe that the BoJ has changed its policy stance: it is starting to recognize that monetary policy may be at or even beyond the point at which it supports growth and can move inflation towards the inflation target (the reversal rate concept).

This means it has abandoned its pre-emptive policy stance aimed at achieving the inflation target and will only react when external risks materialize; these could include a large FX appreciation or global financial crisis. In our view this constitutes a regime change.