In his latest quarterly Economic Outlook, Neil Williams, Group Chief Economist at Hermes Investment Management, sets out his five core macro beliefs for 2018. He argues that, in the Lunar Year of the Dog, the ‘bark’ of global central bankers may end up being far worse than their ‘bite’.
If central banks want their powder back, the Fed’s dual mandate may make sense
While 2017 was (like 2016) dominated by geopolitical risk (North Korea, alleged US/Russia links, European populism), none of that was allowed to seep into financial markets. Lubricated by cheap money, a $15trn sink of QE, and the prospect of US tax cuts, reflation trades have raised the ‘cost’ to investors of missing out, even if they lack conviction.
The frustration for central banks is that recoveries since 2009 have been mainly output driven. Unemployment is a reducing drag. Yet, with output gaps slow to close and wage pressure capped, these recoveries are failing to generate enough inflation to trigger central banks’ usual reaction functions.
This – and hopefully the realisation that prolonging liquidity injections and ultra-low rates may now be contributing to the problem – is the starting point faced by a run of new heads at the US Fed and maybe BoJ in 2018, and ECB and BoE in 2019. They will offer new lenses. Extending inflation targets or broadening them to nominal GDP have their place.
However, if central banks truly want to get their ‘powder’ back, in terms of reclaiming their policy rate while core inflation stays tame, the spirit, if not the letter, of the Fed’s dual mandate (core inflation and employment/output) may make sense for others too.
With major economies having recouped their GDP since the crisis, this may then be seen as ‘hawkish’, especially if US tax cuts go through. But, it would be more than offset if we need to brace for further political distrust, with the threat of beggar-thy-neighbour policies - from the US to an upsurge of anti-European populism - a major risk still unpriced by markets.
In which case, without care, an unhelpful jigsaw piece that prolonged the 1930s depression but was absent from the 2008 crisis - retaliatory trade protectionism - might yet come crashing into place.
Amid these forces, our macro outlook is based on five core beliefs.
First, despite ‘muscle flexing’, the road to monetary-policy normalisation will be long and slow. Real rates will stay negative, with ‘peak’ rates ending up below what we’re used to. The question is how to drain the liquidity ‘sink’ without unintended consequences.
Second, governments will offer fiscal solutions to add stimulus, try to appease electorates, and take back the ‘baton’ from central banks. With Europe still highly-charged politically though, there’ll be little sympathy for a quick, no-strings Brexit deal.
Third, should protectionist forces build, inflation will reappear. But, it will be the ‘wrong sort’ – cost, rather than demand, led. Central banks would ‘turn a blind’ eye as the inflationary flame snuffs itself out. In which case, 2018 could be a ‘year of two halves’.
Fourth, China may tighten policy but still has the tools to support growth. But, fifth, for those emerging markets with high exposure to short-term external debt and foreign saving needs, the outlook’s less rosy.
Regardless, by taking baby steps, central banks want back their powder in case economies slow again. But, this is of course circular, and they’ll be wary that going too far doesn’t cause that downturn. In which case, in the Lunar Year of the Dog, the ‘bark’ of central bankers may prove far worse than their ‘bite’.