By Barrington Pitt Miller & Ian McDonald, CFA
With the upcoming meeting of the European Central Bank (ECB) on September 7, we are nearing yet another potential trigger point in the evolution in global monetary policy. During the meeting, ECB President Mario Draghi could provide additional clarity on the central bank’s plan to gradually step back from its highly accommodative monetary policy. The impetus for the ECB’s action would be an improving eurozone economy. A similar vein of optimism underpins the Federal Reserve’s (Fed) well-telegraphed desire to reduce its $4.5-trillion balance sheet. But as evidenced by consistently low long-term yields, the market sees it differently. We tend to favor the market’s assessment as we do not think global economic conditions merit significant monetary tightening.
Within the U.S., a reduction in the size of the Fed’s balance sheet would represent a tightening of monetary conditions even if it stands pat on interest rates. During the post-crisis era of easy money, developed market central banks have been the marginal buyer of government debt and other financial assets. The removal of this source of demand would likely put upward pressure on interest rates in the countries that undergo balance sheet reduction. This risk is magnified by the expectation that the Fed intends to continue along the path of rate hikes, with another one possibly occurring before year-end.
At present, only one component of the Fed’s dual mandate – the labor market – suggests that further interest rate hikes are in order. With the U.S. jobless rate at 4.3%, one could presume that the nation is not only at full employment, but that wage-driven inflation must be right around the corner, causing FOMC members many sleepless nights. However, wage growth has been and remains notoriously weak, keeping core inflation well below the Fed’s 2% target – the second component of the Fed’s mandate. Without “facts on the ground” supporting rate hikes, the likely rationale for the Fed continuing along this tightening path is to maintain credibility and to provide dry powder in the event of an economic downturn.
Complicating matters – and why we are anxiously awaiting Mr. Draghi’s comments – is the potential for central banks outside the U.S. to move in a similar direction as the Fed. We believe that if material unwinding occurs, especially in an unintentionally synchronous manner, hard-fought global economic growth is at risk of backsliding.
For several years the market has held a more pessimistic view of the robustness of the global economy than major central banks. Consistently, the market has been proven correct. Now, given the stated desire of central bankers to extract themselves from accommodative policy, these diverging viewpoints take on greater significance. We believe that a step toward a more restrictive monetary stance could result in a long-feared policy error if the underlying components of the Fed’s dual mandate do not merit such action. In fact, should the Fed hike as central bank balance sheets are unwound, we worry that the negative impact on economic growth could require the Fed to backtrack and potentially reduce rates by at least an equal amount in 2018.
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