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Four central banks, two policy actions

Mike Keogh

In the coming months, many column inches will be dedicated to the process of divergent monetary policy across the world’s key central banks and the subsequent ramifications for economic growth, currencies, bond pricing and capital flows.

Starting with the US, the Fed has indicated that bond buying will be wound down by October with predictions of a first interest rate rise, albeit very modest and well documented, from 6-9 months thereafter, should strong growth continue. In the UK, better than envisaged growth has persuaded the Bank of England to state that ‘rates could rise sooner than markets expect’, potentially Q3/Q4, even though rates were untouched at 0.5% again this month, and have been for over five years. It would seem there is greater co-ordination (by default or intended) between the US and UK, linked by better growth, stable inflation and falling unemployment.

The same cannot be said of the European Central Bank or Japan where nagging fears of either disinflation, private and public sector deleveraging, are in need of reform or the weakness of the consumer will keep interest rates lower for much longer. Additionally, Sweden, just last week, surprised the market with a 50bp cut in interest rates to just 0.25% in an effort to boost the country's sagging inflation rate, which has long fallen short of the central bank's 2% target rate.

So what will future monetary policy look like?
There are some that believe borrowing rates left at near zero for so long can cause inflationary fears (eventually) in recovering economies, or more worrying, too much cheap money can lead to asset bubbles. These concerns are not unfounded. Pockets of the equity market are at record highs, sovereign bond markets (even those recently deemed of junk status) have recovered rapidly, and real estate pricing has been swift to get back to levels witnessed in 2007 (at least at the prime end of the market). Given this, it is not surprising that rate rises (only in the US and UK) are deemed necessary.

But in order to not cause unwelcome uncertainty and consumer anxiety, it is the benign path of inflation that is likely to mean the curve will not be steep and well documented to the market. In both the UK and US, inflation currently (and importantly over a two year horizon) sits well short of target. Of particular issue is the swift recovery in employment which it would seem has not filtered down into a pressure of wage acceleration. Furthermore, certain excesses look minor to that of 2007; housing bubbles are largely confined to key gateway markets, and macro-prudential tools aimed to restricting certain mortgage lending should temper those fears.

Thankfully, banks in the US and UK are in a better position, from a liquidity angle, than in 2007. The same, as of yet, however, cannot be said for Europe. The need of European banks to hold more capital against ‘risky’ loans should assist in slowing unmerited valuation uplifts in assets, debt and wealth, and hence delay the need to raise interest rates. But ultimately, it is probably the fear of raising interest rates too soon, prematurely edging growth backwards and towards deflation and not inflation, that will keep monetary policy presently unmoved. Interest rates will move higher eventually, but the path to normalisation will be slow, led by the US and UK. As such, real estate for the time being will remain in a sweet spot.

Michael Keogh

Mike Keogh

Director of Research

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