Central banks not ready to throw in the towel

Markets digested a flurry of central bank announcements this week, which all reiterated the determination to lift CPI inflation to targets; with no real signs that central banks have given up on the need for monetary stimulus.

Monday, September 26th 2016, 11:09AM

by Harbour Asset Management

At the beginning of the month, markets were nervous that we might be witnessing the first signs of central banks throwing in the towel – the beginning of the end for unconventional monetary policy. The Bank of Japan (BoJ) announced that they were undertaking a so-called ‘Comprehensive Assessment’, in part to address the costs of ultra-low long-term interest rates on the profitability of banks and insurers. There was also a feeling that the European Central Bank was contemplating similar trade-offs, conscious that there would eventually be a limit to providing more stimulus.

With this background, the meetings of the US Federal Reserve (US Fed), BoJ, and Reserve Bank of New Zealand (RBNZ) this week became even more important, to see if there was any substance to the rumours and worries. In our view, these most recent announcements only served to reiterate the determination of central banks to keep stimulus in place to lift inflation expectations to targets.

US Federal Reserve

The key sentence in the US Fed’s press release was that “the Committee judges that the case for an increase in the Federal Funds Rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives”.

While this tees-up a potential hike in December, at the press conference Janet Yellen was at pains to emphasise that the US Fed has time on its side, enabling moves to be slow and cautious. In particular, Yellen highlighted three main factors that provide the Fed with “more running room”. First, that despite strong job growth, there is still plenty of slack in the labour market as previously discouraged workers return to the workforce. Second, core inflation is still below the US Fed’s target. And finally, in weighing up the balance of risks, the US Fed would rather be too slow to tighten, than too fast and subsequently need to reverse direction.

Importantly, the US Fed has also reduced its long-run assumption for the US Fed Funds Rate to 2.9%. This has edged down in their projections almost every quarter since it was first published at around 4.5% in 2012. The implication is that the US Fed feels that their current policy settings are no longer that far away from neutral.

Bank of Japan

The BoJ is tackling an almost impossible trade-off. On the one hand it faces the biggest battle of any central bank to lift inflation to the 2% target, after a long period of deflation that only ended in 2013. On the other hand, its financial system is being compromised by ultra-low long-term interest rates hurting the profitability of its banks and insurance companies.

In response, this week the BoJ announced a double pronged approach. Firstly, they announced so-called “Yield Curve Control”, where the BoJ will vary the speed and maturity of its JGB purchases to keep overnight rates at -0.1% and to keep the 10 year JGB yield roughly constant at the current level of 0%. Secondly, the BoJ announced a commitment to keep buying JGBs and other assets until they achieve "Inflation Overshooting". That is, not only are they aiming to reach the 2% inflation target, but they want to keep inflation above 2% for a sustainable period.

The BoJ has faced valid criticism that these two policies are conflicting and contradictory. Clearly, putting a lower limit on the yield curve makes it harder to lift inflation. However, the BoJ cannot be faulted for its creativeness or determination to up the stakes on achieving its inflation goal.

Reserve Bank of New Zealand

Finally, the RBNZ released its September Official Cash Rate (OCR) Review, leaving the OCR unchanged at 2.0%, but reiterating its strong easing bias that “further easing will be required”.

There had been some uncertainty in the market about how the RBNZ would treat recent data indicating solid economic activity and a recovery in dairy prices. However, the RBNZ left no doubt that its top focus and priority is to lift inflation back to target, and remove the risk that a sustained period of weakness in headline inflation might cause expectations to get stuck stubbornly below target.

By emphasising that the outlook for the dairy season remains very uncertain, the RBNZ was also able to downplay the recent recovery in dairy prices, and reiterate that “a decline in the exchange rate is needed”. While difficult to engineer, a lower NZ dollar remains one of the quickest routes to lifting NZ CPI inflation and bringing inflation expectations back to target.

- Christian Hawkesby

Important disclaimer information

Tags: Harbour Asset Management Reserve Bank