The recent rise in oil prices has caused a marked increase in headline inflation rates around the world. In the US and UK, which are already operating at or below their natural rates of unemployment, central banks are likely to respond to any rise in inflation expectations by raising interest rates more rapidly. The US Federal Reserve could well start that process next week.
Global bond yields are, however, determined in an integrated global marketplace. Until now, “lowflation” in the eurozone and Japan has held global and US bond yields down, and at times has restrained the Fed from raising policy rates because of a rising dollar. Aggressively easy monetary policy in the eurozone and Japan has also helped to underpin world equity prices.
A key question, then, is whether higher headline inflation in the lowflation economies will persuade the European Central Bank and the Bank of Japan to become more hawkish. If so, global financial conditions could tighten markedly.
We will learn more in the coming week, with crucial policy meetings at the Fed, the ECB and the BoJ in three successive days.
Recent inflation data in the lowflation economies have been greatly affected by the 53 per cent rise in the oil price in dollar terms in the past 12 months.
In the eurozone, the headline CPI inflation rate will probably touch 2 per cent in the next couple of months. This is the top of the ECB’s tolerance range for inflation and it will require a near term increase in the central bank’s forecast path for inflation (blue dots in the below chart) in next week’s meeting of the governing council.
In Japan, the oil price effect raised headline inflation (excluding fresh food) to 1.0 per cent in February, but this has fallen back to an anaemic 0.7 per cent in April. Superficially, it seems that headline inflation is rising very gradually towards the BoJ’s blue dots, and the likely rise in the consumption tax in October 2019 could further close the gap, eventually allowing the BoJ to declare a Pyrrhic “victory” in the battle to attain 2 per cent inflation. This, and the BoJ’s concerns about financial stability, have led some investors to worry about the exit from unconventional monetary policy later this year.
The ECB’s governing council will debate next week whether the three official conditions for ending the asset purchase programme — ie a forecast of inflation in line with target, confidence in that forecast, and confidence that the inflation outlook would be met even after the APP ends — have already been met. Until last week, it had been assumed that this would not be the case, because of the slowdown in eurozone growth data in Q1 and the Italian political crisis.
Somewhat surprisingly, however, ECB rhetoric turned more hawkish last week. Peter Praet, the bank’s chief economist, importantly argued that the economic staff are becoming more confident that the inflation target will be met, even after the APP ends. And the presidents of the Bundesbank and the Dutch central bank have both said that asset purchases could end this year.
The recent rise in headline inflation could be used as cover for ending the APP, though a final decision still seems unlikely next week. The formal announcement will probably come at the next governing council meeting on July 26. This may involve one last extension of the APP from the end of September to the end of December, with the amount purchased being halved from €30bn a month to €15bn. These decisions, which should be viewed as the end of policy easing rather than the start of tightening, would only be reconsidered if there is a significant deterioration in Italian politics, with contagion to other countries.
The start of ECB tightening will finally occur when the deposit rate is raised from its present level of -0.4 per cent. The consensus among independent economists is that this will only occur in the second half of 2019. The ECB seems likely to give some form of additional, dovish forward guidance about this when it announces the ending of the APP.
The key here is that there is very little evidence so far that core inflation has started to rise from its recent underlying rate of around 1 per cent. Although Mr Praet sounded more confident that wage inflation may be rising slightly, the Fulcrum inflation system sees considerable risk that core inflation will remain well below target next year, an outcome that could further postpone the start of genuine ECB monetary tightening.
The BoJ has been conducting a profound experiment in unconventional monetary stimulus ever since prime minister Shinzo Abe appointed Haruhiko Kuroda as governor of the central bank in 2013. Unfortunately, this has consistently failed to restore inflation to the 2 per cent target.
The latest form of this stimulus was announced in September 2016, when quantitative and qualitative easing (QQE) was joined by negative policy rates and a near zero cap on the 10-year bond yield (YCC, or yield curve control). The combination of QQE+YCC implies that real interest rates will fall as inflation expectations rise, adding to the strength of the stimulus.
In some respects, QQE+YCC has not been a complete failure. Headline CPI inflation has (perhaps) emerged from deflation, the output gap has turned positive, unemployment has plummeted and some measures of wage inflation have edged upwards. However, core inflation has barely moved above zero on an underlying monthly basis, and the BoJ’s inflation target seems likely to be undershot for a long time to come.
Any relaxation of YCC is likely to be telegraphed months in advance, and an actual change in rates is unlikely to begin before mid-2019 at the earliest.
The Fed may adopt a more hawkish tone when it raises policy rates by 0.25 percentage points next week, and the balance of risks on US policy rates seems upwards. The ECB will signal its plan to end the APP, which could also sound hawkish. However, core inflation in both the eurozone and Japan remains extremely subdued, and this will prevent any significant tightening by the ECB or the BoJ for a long time to come.