The Federal Reserve’s confidence in the economy and its need to continue to gradually increase interest rates stands in sharp contrast to most of the other major central banks.The European Central Bank will finish its asset purchases at the end of the year, but it is in no position to begin to normalize interest rates. Indeed, the risk is that it may feel compelled to off another Targeted Long-Term Repo, which would, in effect, allow the borrowers to extend the maturities of existing funds. The dramatic drop in oil prices–20% since early October’s four-year highs–will, if sustained, dampen headline inflation, making it more difficult for some countries to raise interest rates. In the US, it may be experienced like a tax break that boosts discretionary household spending and extends the business cycle.
Some critics blame Fed Chair Powell for scaring market participants by noting last month that monetary policy was still accommodative, and there was some distance before neutrality was reached. Should we really harken back to the good old days, when Fed Chair Greenspan purposely sought to obfuscate? Legend has it that he had a sign in his office that said, “If you think you understood what I said, you misunderstood.”
The Fed has been clear. Four hikes are likely this year and three next. The market is not persuaded. In fact, interpolating from the fed funds futures strip, the market is not convinced the Fed will raise rates more than two more times. In some ways, this is nothing new. Throughout this cycle, Fed officials often have had to lead the market by the nose to help it prepare for an imminent hike. In any case, even the market is largely pricing in a rate increase next month and another one in Q1 19. During this period, of the major central banks, only the Bank of Canada and Sweden’s Riksbank are likely to hike rates.
To be sure, the divergence in monetary policy reflect economic and/or financial differentiation. Consider industrial output figures that the US, EMU, and Japan will report in the coming days. Through September, US industrial production has increased by a monthly average of almost 0.3%. It is expected to have risen by 0.2% in October. EMU’s September IP is expected to have also risen by 0.2%, but it has averaged a 0.2% decline in the first eight months of the year. Japan will report a final September industrial output figure. Using preliminary data, including the 1.1% contraction in September, Japan’s IP has fallen by an average of 0.4% this year. Before the outsized decline in September, which appears a function of natural disasters, industrial.
Separately, the eurozone is expected to confirm that Q3 GDP rose 0.2%.This follows a 0.4% expansion in Q1 and Q2. Last year, the eurozone economy expanded by 0.7% each quarter. Growth in the past three quarters is the slowest since 2014.
The 20% collapse in the price of oil, if sustained, will have far-reaching implications for the investment climate. The combination of softer growth and a major headwind on prices (though a weaker euro exchange rate can blunt this) may encourage investors to think twice about the 10 bp hike after next summer that has been mostly discounted (via OIS).
