Article / 31 August 2016 at 11:00 GMT

Central banks scrambling to contain global slowdown

  • Case for a US rate hike remains strong ahead of September FOMC meeting
  • ECB almost certain to extend QE programme
  • RBA changes governors as CPI expansion tumbles
  • Norwegian inflation high and rising, housing bubble in focus
  • Coup attempt derails Turkish economy, further easing expected

Macro outlook
The global economy is listing badly, and central banks' ability 
to right the ship is in question. Photo: iStock

By Christopher Dembik

September will be quite a busy month for investors since there are around 30 major central banks meetings scheduled. Since the Bank of England’s last policy announcement, the total monthly amount in global official quantitative easing has reached almost $200 billion, which corresponds, for the purpose of comparison, to Portugal’s annual GDP in 2015. 

Long-rumoured and oft-discussed, QE infinity is now a reality. Global credit conditions are the loosest they have ever been with the average yield on global government bonds (all maturities included) evolving to around 0.7%.  

The Federal Open Market Committee meeting on September 20-21 is the most crucial monetary policy event this month. There is clearly a case for an interest rate hike, but the final decision of the central bank will depend on the data for the month of August – especially the September 2 nonfarm payrolls report that could confirm the good momentum in the US labour market. 

According to Bloomberg, more than 50% of investors expect a rate hike will happen before the end of the year. 

In the wake of a Fed hike, monetary policy divergence would increase between the US and the euro area, which could further attract attention towards the US dollar. The European Central Bank will have fresh economic data this month that are likely to confirm downside risks are still present. These will encourage the central bank to adjust its asset purchase program at its September 8 meeting. 

Our baseline scenario is that the ECB will extend its asset purchase program by six to nine months and will increase the issuer limits to 50%. 

With the exception of the Russian central bank, the other central banks (Bank of Japan, Bank of England, Reserve Bank of Australia, etc.) should keep rates unchanged since they have already adjusted monetary policy in the past two months. 

Global overview: Any reason to smile?

Is there a light at the end of the tunnel for the global economy? Consensus expected that the global PMI would enter into contraction this summer, which would constitute an early sign of recession. Actually, however, it inched up to a three-month high in July at 51.4. 

This does not mean the global economy is getting better – far from it. The composite PMI output index for developed markets is still very sluggish. The stronger-than-forecasted emerging market growth (the composite PMI output index reached 51.7) is the main explanation behind the relatively solid global PMI performance in July. 

Downward risks are still present, and that’s why central banks remain on alert.

Global PMI

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Source: Saxo Bank 

The numerous central bank meetings scheduled this month could push volatility higher. The rapid reaction of central banks in the wake of Brexit certainly averted a panic this summer. 

Over the past few weeks, the BoJ’s Kuroda and the ECB’s Coeure confirmed they won’t hesitate to act decisively again if needed, which is a clear signal that new measures are in the pipeline. However, one should not misinterpret their words. Global central banks acknowledge that monetary policy is not to remain the only game in town, thus they push more and more to hand the policy baton to the fiscal side of things. 

Fixed income
Source: Saxo Bank 

The case for a US hike

The FOMC meeting on September 20-21 will be the key event this month for investors. There is clearly a case for higher interest rates. Here are six factors that could push the central bank to further normalise monetary policy:

  • The slowdown in the job market seen last spring appears to be temporary. Indeed, the latest economic indicators are quite good, with almost 255,000 new jobs created in July, well above the consensus of 180,000. If the next NFP report confirms this trend, it will give more weight to the arguments of the FOMC members who consider the economy to essentially be at maximum employment. In those circumstances, the Fed will have no excuse for not hiking rates.  
  • The official unemployment rate, established at 4.9%, is close to the NAIRU threshold at which the economy is in balance and inflation pressures are neither rising nor falling. Although the importance of the NAIRU has declined regarding monetary policy assessment, several FOMC members still continue to pay attention to this theoretical indicator that currently indicates it is about time to hike rates.
  • The increase in average hourly earnings, which is closely monitored by the Fed, has accelerated more than expected to a monthly path of 0.3% in July, and stands at its highest rate since the Great Recession;  
  • Financial stress indices are going down. The St. Louis Fed Financial Stress Index is close to its lowest level on record, which goes back to December 1993. 
  • Economic forecasts, which are always a tricky exercise, indicate the momentum is strengthening, particularly through sustained private consumption and durable good orders. The Atlanta Fed GDPNow forecast is currently at 3.5% for the third quarter;  
  • Last but not least, investors need to keep in mind the Fed is in a complicated position. The central bank needs to increase rates before it is too late and that the US enters an economic slowdown. Its strategic mistake is that it has waited too long. The economic situation was good enough in summer 2015 to tighten monetary policy, and the Fed has probably lost a few precious months which could complicate its task. It won't be able to act through changes in interest rates because they are already too low, so it will be forced to start a new program of bond buying that has many disadvantages, notably popping up the prices of financial assets.  
Bridge over troubled water
The US remains a rare beacon in a world of ever-increasing easing. Photo: iStock

We think the possible rate hike in September should go very smoothly because it has already been priced in and, above all, it will not fundamentally change global credit conditions. After all, the scale of the rate increase will be quite low, and is expected to reach a maximum of 25 basis points.

Jobless rate versus NAIRU
Source: Saxo Bank 

Western Europe: No time to rest on its laurels 

The other central bank at the top of the agenda in September is the ECB. Governor Mario Draghi has hinted that the ECB will conduct a review of the impact of monetary policy this month based on fresh economic data. 

This review will certainly focus on the effect of the corporate bond buying program (CSPP) that was launched last June and that has been pretty successful until now. The purchases reach €7 billion euros/month (mostly BBB1 and lower-rated companies), which is quite remarkable given the summer lull. However, risks on the downside remain thus we believe that there is a 100% chance that the review will open the door to further easing. 

The most likely scenario is that the ECB extends QE by March 2017 to six or nine months, which is almost a done deal, and that it sets the issuer limits at 50% instead of 33%. This could allow the ECB to buy more German bonds and it would be a coherent decision considering the likely extension of the asset purchases. 

We cannot rule out further deposit rate cuts but it is a risky monetary policy instrument (as outlined by the last International Monetary Fund staff report on the euro area) that can seriously hurt the profitability of the financial sector. 

Therefore, it is probable the ECB will restrain from using this tool again in the short term. In the long run, the most logical evolution of the ECB monetary policy would consist in increasing the monthly amount of the CSPP in order to lower further borrowing and investment costs for large companies. 

In this matter, the Bank of England showed the way one month ago by deciding to buy corporate bonds up to £10 billion/month.
European Central Bank
Contrary to the ECB, the BoE will adopt a wait-and-see approach at its meeting on September 15. The central bank seems more and more sceptical about QE but it had to announce this sort of combination of measures last month, more for the sake of its own reputation than for that of economic benefits. 

The direct market impact is to lower government bond yields that are progressively heading towards zero. The UK 10-year government bond yield, for instance, fell to 0.55% versus 1.38% pre-Brexit. 

Two conclusions may be drawn from the BoE’s last monetary policy move: 

1) Exit from QE is much more difficult than expected, at least for the majority of central banks.

2) The BoE has already prepared the market for another rate cut by the end of the year. 

For now, negative rates are not an option, thus we can expect the policy rate will fall to 0.10% or 0.05% in the coming months. This move is already priced in by the market. A lower GBP exchange rate is the main objective sought by the BoE in the short term in order to help the economy to overcome Brexit. 

However, what the UK really needs is a “Hammond moment”. The priority is to present a fiscal stimulus plan, which could be put forth by chancellor of the exchequer Phillip Hammond as soon as this autumn.

This would mark a fundamental break with the past and the fiscal consolidation plans presented by his predecessor, George Osborne. 

UK benchmarks
Asia–Pacific: More easing to come…but later

In Asia-Pacific this month, the focus will be mainly on Japan and Australia. “Wait-and-pray” is the new mantra in Japan as the timid measures unveiled last July prove the central bank does not have much room left to act in the current monetary policy framework. 

Since January 1, 2015, the BoJ’s balance sheet has increased by a massive 58% and the yen by 14% versus the US dollar. It is increasingly clear that Japanese monetary policy has not had the desired effect: it has not pushed the country out of deflation (Japan's July CPI print posted its largest annual fall in three years) and it has not succeeded in devaluing the Japanese yen, which is the most direct and massive consequence of accommodative monetary policy. 

In this context, the next step for the BoJ will be when the report on the impact of the current monetary policy is submitted to the government, which should happen by the end of the month. Until then, no new measures are expected by the BoJ at its next meeting scheduled for September 20-21. 

The ball is in the government’s court, monetary policy cannot do much at this level. 

Japan is home to perhaps the world's longest-running experiment in central bank-led 
stimulus, and its prospects appear to be dimming. Photo: iStock

The BoJ is not the first global central bank to recognise that current monetary policy is about to reach its limits. In its last quarterly bulletin, the BoE recognised that the “money multiplier” approach, commonly used by policymakers, does not work. Moreover, RBA governor Stevens, who is leaving office, recently declared that he has “serious reservations about the extent of reliance on monetary policy around the world," explaining that "it isn’t that the central banks were wrong to do what they could, it is that what they could do was not enough, and never could be enough, fully to restore demand after a period of recession associated with a very substantial debt build-up”.

He has perfectly summarised in two sentences the main problem of the global economy: monetary policy has replaced fiscal policy since 2007 but it is not sufficient to boost nominal demand and growth. Fiscal policy is also required to stimulate the economy. 

This is exactly the message sent by the BoJ to the Japanese government one month ago.

BoJ balance sheet
In spite of his scepticism about the effect of monetary policy on the real economy, Stevens decided to cut the cash rate to all-time low of 1.5% last month. This is the end of an era; Australia was well-known for high interest rates which favored the use of the AUD in carry trade strategies. 

The economic outlook is getting quite gloomy. CPI fell to 1% annually in the second quarter, the weakest expansion in 17 years, and consumer inflation expectations weakened again in August. Moreover, growth is expected to decline in the coming quarters. 

Chinese GDP has increasingly become a key driver of the Australian nominal GDP and it indicates us that growth is decelerating. With inflation low and likely to remain low for a prolonged period of time, and considering the risk of economic slowdown, the new governor taking office this month will have to continue to drop rates again in an attempt to run the economy at a faster level. 

The RBA is heading to 1%, but not yet. The central bank will certainly wait to see the macroeconomic and AUD exchange rate impacts from the last rate cut.  

AUD rate
CEE–Russia: Waiting for the storm to pass

In the CEE-Russia area, unchanged policy rates are widely forecasted by the market, except for Russia. The last economic figures could push the Russian central bank to lower interest rates by at least 25 basis points to 10.25% at its meeting on September 16. 

Headline inflation was a bit lower than expected in July, at 7.2% year-over-year versus 7.5% y/y in June, which is the lowest level since March 2014. Moreover, preliminary data point out that Russia just saw its smallest economic contraction since 2014 (minus 0.6% on the second quarter y/y). 

The primary force driving improvement was the industrial sector that benefited from a lower rouble but there are also early signs of recovery regarding consumer confidence and vehicle sales. 

In this context, the central bank could be encouraged to lower rates in order to put the economy on the comeback trail. If it does not stimulate growth, the risk is quite high that the recovery will quickly falter and the economy will decline again, following what happened at the end of 2015. 

Therefore, there is a strong probability the central bank will began a new cycle of rate cuts in September.  

Russian consumer confidence
Most of the countries in CEE are likely to adopt a wait-and-see position, like Poland whose central bank will meet on September 7. The NBP has closed the door to monetary policy easing for now. Therefore, the benchmark rate should stay at a record-low 1.5% until the end of the year. 

However, we don’t share the optimism of the central bank regarding the capacity of escaping deflation. It forecasts that price growth will accelerate to 1.3% next year versus 0.8% in June but the main CPI components point out that downside risks are increasing. 

Is the Polish central bank more bullish than circumstances warrant? Photo: iStock

Compared with the beginning of 2015, only food – which is therefore the primary support for headline inflation – is in positive territory. Energy (electricity and gas) has been heading into negative territory since the end of last year. 

From what we can see, the inflation outlook is worsening and not improving as expected by the NBP. 

In Serbia, the upcoming meeting of the central bank on September 8 should not surprise. The main policy rate is expected to be maintained at 4.25%. As indicated in its last statement, the central bank will wait to have more visibility on the evolution of commodity prices and financial markets before taking a decision on the next step for monetary policy. 

However, a further rate cut of 25 basis points is a done deal by the end of the year. The sharply downward trend seen in the Serbian CPI (which reached 0.3% in June, far below the targets of between 2.5% and 5.5%) and the need to offset the fiscal consolidation pushed by the new government will force the central bank to step in again. 

Finally, the central bank of Hungary will keep rates unchanged at a record-low 0.9%. This summer, it confirmed that it was done cutting and that rates will stay at its current level for an “extended period”. Therefore, there is no surprise to wait for. 

The poor economic performance seen in the first quarter was certainly temporary. Growth is expected to rebound in the coming quarters, driven by strong private consumption growth, improving economic sentiment, and the fiscal stimulus package that will be presented this autumn. 

One of the main black spots of the economy is construction output. The free fall in the sector that has started at the beginning of the year (minus 26.6% y/y in May) could last at least until the end of 2016. However, this very negative trend, mostly linked to the phasing out of EU funding, does not represent a real concern for the country for the moment. 

Nordic: Things are getting very messy for Norway

In the Nordic area, the focus will be on Norway. The consensus expected a new rate cut by the Norges Bank on September 22 but this option is less and less likely due to soaring inflation. For quite a while, the Norges Bank had chosen not to pay too much attention to the evolution of inflation in order to focus on economic growth. 

Accepting an inflation rate of 3.7% (June) despite an inflation target of 2.5% clearly takes some courage. Norway is an exception in a world of low inflation. Although history illustrates that central banks are able to fight high inflation, it seems that the Norges Bank has played with fire for too long. 

Since March, there has been a remarkable acceleration in housing prices (11.14% y/y in July). The central bank got it all wrong because it had forecasted that prices would only increase by 4% y/y. The problem is that the rise in property prices is accompanied by an increase in household debt that is also higher than the Norges Bank assumed last spring. 

In this context, a new rate cut would put into question the credibility of the central bank and its will to maintain price stability. The best solution would be to wait for the storm to pass, hoping the housing bubble will not burst too fast.  

Middle East: Tough Q3 for Turkey

Our worst fears were realized for Turkey. The economy has been severely hit by the attempted military coup. The Turkish business climate index collapsed by 24 points in August while core sales fell by 33% in July compared to the previous month. 

As expected, Turkey’s central bank cut its interest rate for the sixth straight month in August to 8.5%. It is quite unlikely the central bank will be able to fully meet its commitment to maintain high interest rates in order to contain inflation. Political pressure will increase to further cut rates in the purpose to support domestic demand. 

A new rate cut is not our baseline scenario for the central bank meeting on September 22. It is highly probable that the status quo will prevail this month. However, we expect further easing in the coming months and that Turkey’s overnight lending rate will be progressively cut to at least 8% by the end of the year. 

 — Edited by Michael McKenna

Christopher Dembik is an economist with Saxo Bank in Paris
31 August
Michael O'Neill Michael O'Neill
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