Avoiding a mistake
17 October 2017
As global economic data continues to broadly improve, central banks, especially the Federal Reserve (Fed), are reaffirming their commitment to normalising monetary policy. However, with stubbornly low inflation, market participants and economists alike have been questioning such a path, suggesting the Fed may be making a policy mistake. In this edition of the Weekly Economic Briefing, we set out to highlight what economic indicators we are following closely in order to assess whether a mistake has been made. While we are relatively upbeat about the ability of the real economy and financial markets to absorb reduced policy accommodation, given political uncertainty and unprecedented length of time accommodative policy has been in place, the impact may be less straightforward than in past cycles.
With the Fed signalling a more aggressive path for rate hikes and balance sheet reduction than expected earlier in the year; the Bank of England shifting its rhetoric to reflect a desire to avoid overheating; the ECB foreshadowing plans for tapering its asset purchase programme; and the People’s Bank of China tightening liquidity and raising policy rates, the global economy is now faced with the first synchronised tightening by major central banks since the global financial crisis (see Chart 1). While this naturally brings some trepidation, especially given recent disinflationary surprises, recent robust data suggests a policy mistake is not in the offing. Although there can be a significant lag before a policy mistake would be evident in the data, in the US and China, where rates have increased steadily over 2017, leading indicators, such as labour market data and consumer sentiment, have calmed nerves by showing continued improvement. In emerging markets (EM), where Fed tightening can reduce capital flows, net portfolio flows for 2017 are set to double the total amount seen over 2015-2016, while currencies have been broadly stable. Going forward, the main unknown remains political risks – how will Brexit negotiations affect the economy? Who will lead the Fed and will this presage a change in policy? How will US protectionism affect the domestic inflationary outlook and EM growth? While confident in the underlying recovery, these questions may vex central banks.