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Monetary policy lines are starting to diverge

The robust economic recovery is not going unnoticed by the world’s central banks. Is the end of ultra-expansionary monetary policy approaching?

Amid the breathtaking scenery of the Rocky Mountains’ Teton Range, central bankers, economists and politicians will be gathering in the US resort town of Jackson Hole from 26 to 28 August – the first physical meeting planned since the outbreak of the pandemic. In light of rising inflation, one of the most-discussed topics at this meeting will be when the anticipated shift of the US Federal Reserve (Fed) to a tighter monetary policy regime will begin. Another hot topic will be whether US President Joe Biden will confirm Fed chair Jerome Powell in office next February in spite of criticism from some Democrats.

While last year’s meeting was dominated by the coronavirus crisis and the adjustment of the Fed’s monetary policy strategy (which had been planned since well before the pandemic), this year’s monetary policy summit is taking place in a more upbeat environment. The spread of the delta variant of COVID-19 does pose certain economic risks and the lingering conflict between China and the US and its associated deglobalisation drivers could put a dampener on global trade. But the economic recovery that has taken hold on the back of progress with vaccination programmes and the easing of coronavirus-related restrictions has reached quite an advanced stage now – especially in major economies – and has so far remained intact.

Iceland breaks the ice

This is also reflected in the fact that we are starting to see divergences from the highly coordinated monetary policy approach that central banks around the world had been taking during the crisis. For some time, global monetary policy was purely geared towards supporting the economy and the financial system. But now, a few central banks have already started to raise interest rates again – even in Europe. Iceland’s central bank broke the ice in May when it raised its key interest rate by 25 basis points to 1.0 per cent in light of the strong economic recovery.

The differential between the reference rates of some central banks is growing

The first central bank of an EU member state to follow suit was Hungary’s Magyar Nemzeti Bank with an interest-rate hike in June, followed by the Czech central bank. Both cited a significant rise in inflation in their countries as a reason for this step. The central banks of Russia and Brazil also raised their reference rates (see chart). Institutions such as the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) are currently still one step away from raising interest rates. However, they have taken (BoC), or soon intend to take (RBA), the first step toward phasing out their monetary policy stimulus by scaling back asset purchases.

Fed likely to commence tapering around the turn of the year 2021/2022

The European Central Bank (ECB), the Fed and the Bank of Japan (BoJ) are a bit further behind. But while the ECB is keeping its asset purchases under the pandemic emergency purchase programme (PEPP) at a very high level, the discussion about an exit from quantitative easing (‘tapering’) is gaining traction in the US. Recently, robust US labour market data and persistently high inflation rates added fuel to speculation about a potential start of tapering measures in the near future.

However, Union Investment’s economists remain confident that the current surge in inflation as a result of pandemic-related distortions and effects linked to the reopening of the economy is painting an overblown picture of the underlying price trend. In addition, there are currently no signs of second-round effects or the beginnings of a wage-price spiral. Inflationary pressure will probably strengthen slightly overall in the coming years from a broad structural perspective, but the Fed will ensure that, over the medium term, its target of 2 per cent inflation on average will be exceeded only marginally, if at all.

When choosing the right time for a gradual commencement of tapering, the Federal Reserve will also keep an eye on the second parameter of its mandate: maximum employment. In this respect, Union Investment assumes that the supply of workers will rise sharply from late summer/autumn 2021 onwards and that important labour market metrics will improve markedly. As a result, the Fed should make “substantial further progress” towards its inflation and employment targets by the end of the year, thereby satisfying its self-imposed criteria for a reduction of bond purchases. In this scenario,tapering is likely to begin around the turn of 2021/22. The Fed’s first interest-rate hike would then probably follow in the first half of 2023.

Widening interest-rate differential between the US and the eurozone

What does this mean for investors in practical terms? If Union Investment’s assumptions are accurate, the continuing economic recovery would promote a moderate rise in real rates of return. A decline in inflation would also lead to a dip in inflation expectations, meaning that the prices of nominal bonds would probably outperform those of inflation-protected bonds. One possible way for investors to respond to this trend would be to implement an investment strategy that includes inflation swaps and bond derivatives. On the currency front, the risk of a sharp depreciation of the US dollar in anticipation of an inflation-driven fall in the value of US-dollar investments seems very limited. All in all, an environment of economic growth paired with moderate inflation should also keep the equity markets well supported.

And what about Europe? The ECB is still several steps behind the Fed, as recently underlined both by the announcement of its new monetary policy strategy in June and by the meeting of the Governing Council in July. The two major central banks on either side of the Atlantic are thus beginning to show signs of divergence. This drifting apart should provide support for the US dollar as monetary policy stimulus is likely to be withdrawn earlier in the US than in the eurozone. Higher real interest rates are likely to cause a further appreciation of the dollar. A growing number of central banks around the world are also shifting to a more hawkish (i.e. less expansionary) line than that of the ECB. One effect of this trend is that it is causing smaller currencies such as the Czech koruna and the Norwegian krone to appreciate against the euro.

ECB unlikely to raise interest rates before 2024

First, the ECB will need to decide whether it wants to extend its PEPP beyond March 2022 in order to ensure that the economy is firmly on course for recovery to its pre-pandemic trajectory and that inflation is therefore also coming back into line. Union Investment anticipates that the ECB will continue to purchase bonds in considerable quantities even after a potential termination of the PEPP in March 2022 and that it will continue to support the eurozone economy for some time yet. The bank is keen to ensure that financing conditions do not deteriorate too much, too soon or for the wrong reasons.

In July, the ECB reiterated that it was possible that inflation would temporarily rise moderately above the target level of 2 per cent. In this context, the bank would be taking into account that interest rates are currently more or less as low as they can be. Whether the ECB will actively promote a rise in inflation above 2 per cent or whether it will merely tolerate it if it happens, remains a point of contention among the members of the ECB’s Governing Council.

Net asset purchases are consequently not expected to come to an end until the end of 2023, meaning that a first interest-rate hike is unlikely to happen before 2024. This should keep yields on government bonds from the eurozone periphery and euro-denominated high-yield corporate bonds well supported for the time being. By contrast, yields on ten-year Bunds will probably go up only slightly.

ECB: pace of asset purchases to remain high, extension possible

 

As at: 16  August 2021.