Financial markets have calmed since the spring. However, according to Neil Williams, Group Chief Economist at Hermes Investment Management in his latest Economic Outlook, with macro recoveries and corporate earnings below par and vulnerable, central banks daren’t remove the tide of liquidity covering the sharp rocks beneath. After seven years, though, their monetary tool boxes look bare.
The Fed having raised rates once is the test-case for whether central banks can ever ‘normalise’ monetary policy. We expect it to try, hiking twice more, but peaking out early at just 1%. This suggests another two years of negative real rates in the US and UK.
Slower-growth economies may as well relax fiscally - given QE is already capping their bond yields...
Deflation-prone Japan and the eurozone can’t be sure of that. The eurozone is halfway down the Japan route. It too may be accelerating QE and running negative rates, but has yet to loosen the fiscal reins. Its sharp deficit reduction, though, suggests it can.
‘Helicopter money’ is considered a next step. The absence of a eurozone-wide fiscal agency precludes a unified giveaway akin to the US tax-rebate cheques. But it could still be done nationally, with reform back-end-loaded to allow growth and protect ratings.
EU exit fears could extend beyond June and beyond the UK...
A complication is the UK referendum. Brexit can still be avoided, but exit-fears could extend beyond June and the UK. With the EU’s relative safe haven status questioned (and as the ECB runs QE), this could benefit the US dollar - putting an extra, early brake on the Fed’s normalisation.
And with general elections due next year in France, Germany, and potentially Italy and The Netherlands, they may have little sympathy for a quick, ‘no-strings’ UK deal. The (next) UK Chancellor may yet have to forego returning to budget surplus by 2019/20.
China’s dilemma is to cut borrowing costs while property transactions outpace new building starts by about two-to-one. There too, the result is probably fiscal expansion. The big macro risk is a policy face-off between US rate hikes and renminbi devaluations.
In the meantime, central banks seem hell-bent on QE, despite its patchy success in lifting inflation. As we know from Japan, the main benefit is to keep bond yields down for longer - as others now attest. (Please see chart below.)
In which case, with growth under threat, funding costs low/negative, and infrastructure needs high, it surely makes sense for stubbornly slow-growth Europe and Japan to relax fiscally – using the aggressive QE they’re doing anyway to cap any subsequent rise in bond yields.
Japanification – is Japan leading the way on QE?
Shows 10-year JGB yield, vs 10-year German Bund yield lagged 15 years (both %)