The holiday period has also drawn to a close for the central banks. After playing hide-and-seek with investors throughout the summer months, it is now time for some clarification. The US and European central banks are expected to announce plans to reduce their balance sheets during the autumn and the Fed may even be considering a further hike in base rates in December. But how is it possible to plan tightening monetary conditions with inflation remaining significantly below the 2% target level in Europe and in the US?
To answer this question, we have to consider the central banks’ remit. During the 1970-1980s, faced with strong inflation (7% on average in the US) the central banks set price stability as their primary objective. Their assignment was to correct any exaggerated cyclical price fluctuations, triggered by external shocks, excessive domestic demand or pressure from the jobs market. In this context, the central banks have demonstrated and advocated independence vis-à-vis political bodies, even though the Fed also seeks to support the employment market. Against this backdrop, the European Central Bank was set up with a primary objective of maintaining price stability. Germany, still haunted by the spectre of the inflation rates seen in the 30s, imposed a monetarist interpretation of this objective on its partners throughout the 2000s.
The 2008 financial crisis marks a turning point however. This summer, Mario Draghi took the pleasure of reminding the markets that “when the world changes as it did ten years ago, policies, especially monetary policy, need to be adjusted that’s obvious for most people, but not for everybody”. In other words, the central banks had to adapt, particularly in order to guarantee financial stability. After cutting base rates to almost zero and providing massive liquidity facilities, central banks also introduced the so-called non-conventional measures involving:
The scope of the central banks’ remit has therefore automatically broadened in order to protect the financial system from speculation and avoid the collapse of the banking and finance. In this context, central banks have become the guardians of the new prudential macroeconomic policies. In 2012, the BoE set up a new committee called the Financial Policy Committee. In 2014, the ECB became the sole supervisor for European banks. In July 2017, Donald Trump nominated Randal Quarles as the Fed member in charge of banking supervision.
Today, monetary policy cannot be interpreted solely as a function of the inflation rate. The traditional Taylor rule used to define an optimal equilibrium real interest rate has become redundant and no longer acts as a crystal ball for investors. Base rates have never before been so low compared to the equilibrium real interest rate. Implicit financial stability objectives therefore have to be taken into account in order to understand and anticipate central bank policy. These objectives involve a certain duality, on the one hand providing support against market downside, while also avoiding overpricing. Factors such as the overvaluation of US equities and real-estate markets in certain European countries, along with the risk of a sharp rise in sovereign yields in Europe, are now fully taken into account by the central banks in their analyses.
With inflation remaining sluggish in Europe and the US as we head into September, we believe that the Fed will gradually reduce the size of its balance sheet and may also consider a further base rate hike between December of this year and March 2018. Meanwhile, the ECB is expected to announce in October plans to continuing buying-up bonds, albeit at a reduced rate of 40 billion per month, prior to tapering the programme in the second half of 2018. A rate hike would now appear to be excluded for the next few months even though such a move would make a great deal of sense for the European baking system.
Exit policies are always a delicate process. The Fed has started the ball rolling and the ECB is expected to follow suit. It would be naïve to believe that these policies are purely linked to the inflation rate, as they are increasingly dependent on other factors. All the more so in 2018, as the planned nomination of the successors to Janet Yellen and Mario Draghi will logically trigger the question of current policies being maintained and the independence of the central banks vis-à-vis the states and banks that they support.