Tinkering, flattery, and the return of inflation
- BoJ, FOMC outcomes signal decreasing efficacy of policy shifts
- Yield curve control an interesting new central bank dynamic
- Fed policy continues to flatten yield curve, buoy risky assets
By Neil Staines
"I am a fiscal hawk" — Vinod Khosler
After a slow start to the week, activity and intensity picked up yesterday with the scheduled monetary policy announcements from the Federal Open Market Committee and the Bank of Japan. While the market’s focus on the central banks’ words and actions were acute, there were implicit and explicit signals from both that the marginal efficacy of monetary policy is diminishing (or even diminished).
From our perspective, this signifies an important transition for the global economy, a shift away from monetary stimulus towards fiscal stimulus and structural reform. If fiscal stimulus is bold and appropriately targeted, then it could also signify the return of business investment, growth impetus, and ultimately inflation.
If our view is right and we are at the start of a process of transition in the global economy that could presage a return of (potentially significant) inflation, then the medium term forecasts of all major central banks, and the market for growth, inflation and both financial and real assets would have to change – perhaps significantly.
This is a theme that we intend to monitor and communicate over the medium term. Today, however, we discuss the detail of this week’s monetary policy meetings and the near-term implications as we see them for financial markets.
"Take a Rover 25 and glue a spoiler to the back of it" — Jonathan Ferro
First up was the Bank of Japan. Earlier in the week we suggested that there was a risk of a lower policy rate and a further move away from QQE and towards interest rates as the main policy tool. What we actually got was “QQE with yield curve control”.
While this may sound like an optional extra for a Ford Mondeo, it is potentially a very interesting (if subtle) development as the BoJ moves away from a fixed expansion of the monetary base and using the shape of the yield curve as a policy tool.
In addition to the QQE with curve control (scrapping the average maturity target of Japanese government bond holdings and targeting a positive 10-year JGB yield ), the BoJ raised its inflation target. In essence, the implied shortening of duration on bond holdings and the implicit steepening of the curve could both be seen as tightening monetary policy and are likely explicitly aimed at restoring banking and insurance industry stability.
Raising the inflation target (particularly when the bank has singularly failed to hit the previous, lower target) reaffirms a strong commitment to higher inflation and is the core easing measure – that is, providing it generates higher market inflation expectations.
However, judging solely by the price action the market has yet to be convinced that the BoJ has altered the likely path of inflation, growth or interest rate trajectory by its actions yesterday. As per our opening discussion, a return to inflation in Japan is increasingly reliant on Arrow 3 structural (or fiscal) reform.
"Audacity augments courage; hesitation, fear" — Publilius Syrus
In the US, we had cautioned that the market was perhaps too complacent in its view of Fed inaction and a dovish statement. Despite a modestly hawkish voting composition, however, such complacency, was not punished.
Whether or not the FOMC's caution is a function of the recent rise in Libor rates (a technical response to money market reforms set to come into place on October 14), the upcoming uncertainties surrounding the market reaction to the presidential race, or even global economic or geopolitical risks, the actions of the Fed continue to disappoint hawks, flatten the yield curve, and buoy equities and risky assets..
Balancing the statement that the Fed will “wait, for the time being, for more evidence”, chair Yellen stated that continued economic momentum at the current pace and “no new risks” would justify a hike this year (December is the only likely option).
Kansas City Fed chief Esther George was joined by two further voting members (Rosengren and Mester) dissenting in favour of a rate hike, strengthening this sentiment.
The damage to interest rate expectations and the USD, however, was done by the lowering of the longer term rate projection to below 3%. While this was something that we discussed earlier in the week, and was expected by many, its announcement drove longer-dated Treasury yields lower, and the curve flatter.
"Knavery and flattery are blood relations" — Abraham Lincoln
This is a key area of difference in the (central bank-guided) market response to yesterday’s monetary policy meetings. In the US, "wait and see" in the near term and a lowering of rate expectations further out drove a flatter curve that weakened the USD across the board.
BoJ governor Haruhiko Kuroda, on the other hand was explicit in stating that “excessive flattening of the yield curve may be negative for the economy”, and the anchoring of the 10-year JGB yield in positive territory ultimately drove the JPY higher.
We would agree with Kuroda’s yield curve sentiment and would expect major central bank yield curve flattening to begin to re-steepen going forward.
While it can be argued that medium-term inflation differentials will continue to favour further JPY gains, real yield differentials could well underpin a volatile USDJPY in the near term. If we are right about the return of inflation, then this could bring about a new wave of JPY weakness.
Neil Staines is head of trading at The ECU Group