Monetary policies: let’s be honest

We still expect too much from the central banks, and there's no risk of that stopping any time this year.

After a seven-year stretch of ultra-accommodative monetary policy, the Fed timidly raised its key rates by 25 bp in December after promising to do so a year ago. One month later, rate hike expectations collapsed, the stock markets shed 10% and a mere 25-bp increase is now in the cards – for end December – on the Fed Funds Futures markets. And yet, over a track record spanning more than 30 years, the Fed has always raised its rates more than once during all previous rate-hiking cycles. If the markets prove right, we would be in an unprecedented situation, indicating that the Fed was wrong to raise its rates and that the greater-than-expected risk of a slowdown is weighing on the US economy. However, given how things currently stand in the US (growth and inflation rates), any Taylor rule you care to apply points to a target rate of 3%. And the members of the Fed aren't saying any differently, having announced a long-term equilibrium rate of 3.50% (and 1.37% for end-2016). It's just that the markets, which have ridden the QE high for nearly a decade now, don't want to believe it. Let's be honest: no one likes to see a happy story come to an end.

In Europe, Mario Draghi's December 2015 press conference was a bitter pill for many investors to swallow. While many were expecting the ECB to pick up the pace of its bond buying programme and to dramatically cut its deposit rate, the central bank barely lifted a finger, almost as if the hawks were gaining ground again. One month later, the tone changed, with the ECB President hinting during the latest press conference at additional actions in March in the wake of revised growth and inflation projections. And the reasons given? The steeper drop in inflation and inflation expectations. But who has control over headline inflation? The European inflation rate, mainly a function of commodity prices, will not climb with lower interest rates. And it was just as dumb to raise interest rates in 2011 because oil prices rose as it would be naive to lower them in 2016 because oil prices have fallen. That's not where the real reason lies. Mario Draghi cannot accept that the European stock market has lost 10% so far this year, or that credit spreads have widened to such an excessive degree. Let’s be honest, everyone prefers good news.

Central banks in Japan, China and elsewhere are following the same path. One of these days, the recent appreciation of the JPY (+5% in TWI) will be countered by another move by the BoJ, which cannot accept being the loser of the well-known game of competitive devaluation. In 2016, we may well see Governor Kuroda plotting another balance sheet expansion. Meanwhile, the Chinese authorities are busy learning the rules of the game, at their own expense. And if the Chinese markets continue to suffer, the Bank of China will be forced to launch additional accommodative measures.

In order to combat deflation risk, central banks around the world have and are continuing to inject massive doses of liquidity. We are gradually reaching the end of the game in the US, which should drive the other central banks to take up the baton with new accommodative policies. Faced with the volatility gripping the markets, Ms. Yellen no longer has much of a choice. As the Chinese saying goes: “If you move forward, you die! If you move backwards, you die! So why move backwards?”