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Fixed-Income Insights

Here’s a look at the challenges faced by the U.S. Federal Reserve, European Central Bank, and Bank of Japan as they seek to unwind years of monetary accommodation. 

 

In Brief

  • The U.S. Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of Japan (BoJ) face challenges as they attempt to scale back accommodative monetary policies.
  • For the Fed, a lack of inflation could prevent implementation of a possible rate hike in December 2017 or the three hikes that policymakers have projected for 2018.
  • Like the Fed, the ECB is contending with below-target inflation throughout the eurozone, as it attempts to reduce bond purchases. The central bank also has been hamstrung by continued strength in the euro versus other currencies.
  • Low inflation and the prospect of slower economic growth are hampering the BoJ’s efforts to reduce monetary accommodation, especially the size of its holdings in Japanese government bonds.
  • The key takeaway: Unless inflation rises meaningfully, or economic growth pushes above current trends, major central banks may continue to struggle with raising rates or tapering quantitative easing.

 

Central banks of the developed world, especially the U.S. Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of Japan (BoJ), would prefer to move the accommodative monetary policy of the last several years toward normalization. This means that the Fed would like U.S. interest rates to approach a “neutral” level that does not reflect the overt influence of monetary policy; that the ECB would like to scale back its aggressive purchases of fixed-income securities under its quantitative easing (QE) program; and that the BoJ would prefer to reduce its dominant role as the primary financier of Japanese government debt. 

But the road back to normal won’t be smooth. Although improving economic growth should allow central banks to pursue their respective traditional monetary policy paths, other factors, such as persistently low inflation, a lack of fiscal stimulus from government, currency issues, and geopolitical concerns, all represent headwinds to reducing monetary accommodation. Unless inflation accelerates toward policymakers’ stated target rates, economic growth pushes above current trends, or wage growth jumps higher, the central banks of major developed countries may continue to struggle with raising rates or tapering QE. 

In short, current global monetary accommodation seems likely to prevail longer than policymakers would prefer. What follows is a rundown of the challenges faced by these three leading central banks.    

U.S. Federal Reserve
The Fed continues to encounter developments that frustrate its pursuit of interest-rate normalization, a process that has been proceeding at a glacial pace compared with past cycles. The modest GDP growth rate of 2% recorded since the end of the 2008–09 recession has engendered a prolonged recovery (seven years and counting), but one that has yet to approach the average growth of past rebounds. Neither has the slow recovery pushed against typical limits to growth, such as capacity utilization, which produce higher levels of inflation and the justification for rate hikes.

It’s the lack of inflation that could prevent the Fed from pursuing a rate hike in December 2017, or the three hikes that policymakers have projected for 2018. The Fed’s preferred measure of inflation, personal consumption expenditures excluding food and energy (i.e., core PCE) has indicated slowing inflation during 2017 rather than the rising trend the central bank expected.  The price index has consistently declined, from 1.8% in January to 1.4% for the most recently published figure for July, according to the U.S. Department of Commerce.  The Fed continues to look for evidence that will bolster its confidence that inflation will reach the Fed’s 2% target in the “medium term.” 

Unfortunately for the Fed, even wage inflation has been unable to increase above 2.5% over the last five months, despite the decline in the unemployment rate, from 4.8% to 4.4%, during the first eight months of 2017, according to the Bureau of Labor Statistics. Commentary from several Fed members in early September suggested that low inflation may prevent the rate hike signaled in the “dot plot” predictions in 2017. Combined with increased geopolitical concerns regarding tensions with North Korea, the renegotiation of the North American Free Trade Agreement, and precarious contention in the South China Sea, it is not surprising, then, that investor expectations for a December rate hike have dropped below 30%, according to Bloomberg.

Passage of U.S. fiscal stimulus programs, such as tax reform, infrastructure spending, and repatriation of cash held outside the United States by U.S. corporations, could spur economic growth and higher inflation, potentially allowing the Fed more latitude to pursue rate hikes in 2018. However, the lack of legislative success by the current U.S. Congress has increased widespread skepticism that fiscal stimulus will be enacted, or be of any meaningful use. As such, investors expect only one rate hike between now and the end of 2018, according to Bloomberg. Unless the outlook for inflation increases as a result of improved economic growth, higher wages, or other exogenous factors, the Fed may be unable to pursue its planned rate hikes. Investors, then, will have to weigh the likelihood of slow, or even nonexistent, U.S. interest-rate increases well into 2018, and adjust their portfolios accordingly.

European Central Bank
The ECB faces a situation similar to that of the Fed, with slightly different headwinds to its policy intentions. Economic growth in the European Union of 2.1% and 2.3% in the first two quarters of 2017, respectively, represents the strongest six-month period in a decade, and further supports the ECB’s ability to reduce accommodation. According to Reuters, economists expect the ECB to begin tapering security purchases in January 2018 and generally expect the process to be completed by the end of 2018.

Like the Fed, though, the ECB does face some obstacles to policy normalization, potentially leading to a tapering process that could be slower than expected. Inflation, at 1.5% in both June and July, came in lower than readings of the first five months of the year and, as in the United States, falls short of the central bank’s target of 2.0%. The ECB is earlier in its policy cycle than the Fed is, and has more time for inflation to rise, but low inflation could cause other difficulties. For one thing, it could continue to suppress wage growth. Any policy shift by the ECB that might slow the eurozone economy risks alienating voters in some of the member nations, who in the past have shown a willingness to elect candidates skeptical of the value of European economic and currency union. The ECB must be careful in tapering its QE to avoid a “taper tantrum” of rising rates and the potential domino effect of slower growth creating angry voters, potentially leading to eurozone fragmentation. 

The policy risk is made more acute by the strength of the euro. The 12% increase in the common currency during the first eight months of 2017 impedes economic growth by reducing exports and pressures inflation lower via cheaper imports. If investors expect the ECB to taper QE purchases rapidly, potentially leading to higher rates, the euro could further strengthen, based on more attractive, short-term fixed-income investments and the economic confidence implicit in the ECB’s move. The economic, political, and inflationary consequences of additional euro strength are likely to temper the ECB’s pace of QE reduction. Again, monetary accommodation may last longer than many economists expect, restricting the rise in eurozone rates through 2018. 

Bank of Japan
The BoJ faces difficult issues as well. Although Japan’s economic growth has improved in 2017, allowing the central bank to twice revise its economic assessment higher this year, inflation, at 0.0%–0.5%, remains far short of the BoJ’s target of 2%. At its most recent policy meeting in July, the BoJ cut its inflation forecasts for the next two years and pushed back the timing for reaching 2% inflation, to “around fiscal 2019.” According to Reuters, this is the sixth time the BoJ has delayed the timeline since the central bank’s governor, Haruhiko Kuroda, unveiled the central banks’s program of quantitative and qualitative monetary easing in 2013. With inflation at such low levels today and the BoJ’s expectations for slower economic growth in the next two years, reaching the 2% target anytime soon appears to be remote. As such, a meaningful reduction in monetary accommodation seems unlikely, despite the fact that as of July 2017, BoJ holdings accounted for 44.3% of the Japanese government bond (JGB) market, according to Japan Macro Advisors.

In fact, it may be argued that the BoJ’s securities purchases could increase if the yield on the 10-year JGB issue increases in sympathy with a rise in yields on U.S. or eurozone 10-year government debt. Such was the BoJ’s response in June when the yield on the 10-year JGB rose, to 0.113%. At that point, in addition to regular purchases, the BoJ offered to buy an unlimited amount of 10-year JGBs at a yield of 0.11%.

Summary and Strategy
By itself, stronger economic growth this year in the United States, the eurozone, and Japan should allow central banks to reduce their level of accommodation and proceed toward policy normalization.  Persistently low inflation, however, combined with the economic and political risks of rates rising too quickly, suggest steps toward policy normalization will be restricted. 

Despite the intentions and hopes of central banks, ultra-accommodative conditions seem likely to prevail through 2018. Among the investment consequences market participants should consider are: equity valuations likely will be sustainable without rates rising more rapidly; short-duration debt may become subject to potentially fewer rate hikes; high-yield securities could benefit from relatively attractive income and low defaults amid solid, if unspectacular, economic growth; and fixed-income securities from emerging markets may face less rate competition from comparable issues of developed countries.

 

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