Game on for central banks

Paul Wallace reports on how central bankers are rewriting the script for April 2019

After calling the shots over the past decade, central banks were supposed to take a bow from now on. The prevailing narrative was that in 2019 they would cease to be the only game in town. Investors and traders would have to look elsewhere for direction. But it isn’t working out that way.

The US Federal Reserve (Fed) wrote the original storyline. It envisaged further tightening in monetary policy in 2019, after a year in which it raised its policy rate in four quarter-point steps, reaching 2.25% to 2.5% in December. The Fed would also continue its policy of ‘quantitative tightening’, introduced in October 2017, through which it is running down the pile of assets it bought with newly created money through three rounds of quantitative easing (QE) from late 2008. That shrinkage has been occurring automatically as bonds mature (rather than through sales), at a monthly average of around $40bn since Q4 2018.

Where the Fed led, the European Central Bank (ECB) was due to follow – though from a long way behind, reflecting its late adoption of QE in 2015. When the ECB ended its asset-purchase programme in December, the ECB made clear that it was in no hurry to start shedding its portfolio. Instead it would maintain the stock of assets at €2.6trn by reinvesting the proceeds of maturing bonds. Like the Fed in late 2015, a rate rise would be the first baby step in withdrawing stimulus. The ECB signalled that this would come no sooner than the autumn, leaving its key deposit rate at -0.4% at least until then.

Both banks have now unceremoniously junked their plans. The Fed was first off the blocks in early January when Jerome Powell, its chairman, said that it would be “patient” and “flexible” in its stance. At the end of the month it showed that patience by taking rate rises off the table for the time being. And it demonstrated that flexibility by indicating that quantitative tightening would come off “autopilot” – the term Powell had used in December. The rundown of assets would end sooner than in previous estimates, leaving the Fed with a far bigger balance sheet than before the financial crisis. To date it has shrunk from $4.5trn to $4trn; in early 2008 it stood below $1trn.

The ECB, which was prepared to take its time tightening policy this year, was swift to emulate the Fed. In early March it made clear that there will in fact be no rate rise this year. Moreover, the ECB is going to provide yet more stimulus. That will be through a new bout of bargain-basement long-term loans to the banks, a remedy it first prescribed at the height of the euro crisis in late 2011 and early 2012 through three-year longer-term refinancing operations (LTROs) worth €1trn. As in a further round from 2014 to 2017, the new funding will be tied to additional lending by the banks; in ECB-speak it will be “targeted”. The TLTROs, which will last for two rather than four years, will be made available every quarter from this September until March 2021.

The Bank of England, whose task is complicated by Brexit, has also swerved. The Bank was already well behind the Fed because it had to ease monetary policy again after the shock to the economy of the referendum result in June 2016. As a result its interest rate stood at just 0.75% at the start of 2019, following quarter-point rises in November 2017 and August 2018. That tempo of a rate rise a year was previously set to quicken a bit, but it is now likely to remain glacial. That assumes an orderly Brexit; if it occurs without a deal, the Bank might have to cut rates again.

Meanwhile, the stock of gilts it has bought remains stuck at £435bn, the amount reached after the additional £60bn bought in the wake of the referendum. One reason all three central banks have changed their tune is the global slowdown arising from China’s ebbing growth. The deceleration has been particularly acute in the euro area. In the annus mirabilis of 2017, when growth was the fastest for a decade, the monetary union expanded at a quarterly average rate of 0.7%. But, by the second half of last year, it grew by a mere 0.1% and then 0.2% while Italy slid into recession and Germany narrowly dodged one.

In Britain, the Bank is forecasting a further slowdown in 2019 even if a no-deal Brexit is avoided. That would follow growth last year of just 1.4%, itself the most sluggish in the recovery since the financial crisis. The knock to the economy this year stems from the intensifying uncertainties induced by Brexit as well as from the global slowdown. The US grew at a respectable rate (at 2.6% annualised) in the final quarter of 2018. But that was much slower than earlier in the year and there is increasing concern about how much longer an expansion already close to the longest on record can continue.

A more fundamental reason why central banks are finding it difficult to move the monetary dials back to more familiar settings is that inflation remains low. Wages growth has belatedly picked up on both sides of the Atlantic. Yet pay is still increasing at a moderate pace given how far unemployment has fallen, to just 4% of the labour force in both the US and Britain.

The bigger picture is that consumer prices remain shackled while expectations for inflation are subdued especially in the euro area and the US. In the euro area, headline inflation is within hailing distance of the ECB’s target of just below 2%. But core inflation has been stuck for years at around 1%. In Britain, inflation picked up after sterling’s big depreciation following the referendum vote. But the rise was contained to a peak of 3.1% and inflation fell back in January below the 2% target after almost two years above it.

Financial forecast

The abrupt turnaround in the stance of all three central banks suggests that the return to more familiar monetary terrain will be protracted, if indeed it occurs at all over the next few years. As central bankers remain centre stage, investors and traders will have to continue scrutinising their every word. That’s a difficult task since there is now a surfeit rather than a shortage of communications. Central banks will retain pumped-up balance sheets for longer, keeping commercial bank reserves similarly swollen. That will protect banks from liquidity crises caused by funding famines as occurred in the financial crisis. But the worry now is that of market liquidity drying up in flash events.

For insurers and asset managers, the crucial issue is the quiescence of inflation. As long as it remains so tame and real interest rates are kept down by long-term factors such as demographics, bond yields will stay historically low. Worries about a possible repeat of the bond-market crisis of 1994 look hopelessly out of date, not least since central banks rely so heavily now on signalling their intentions.

The broader lesson is that the old norms no longer hold. If the Fed’s pause does indeed mark the turning point for interest rates in this cycle, that peak of 2.5% will be very low. Although high debt means that rates do not need to rise as much as in the past it still leaves the Fed with little room for manoeuvre if a recession does occur. That margin is even slimmer in Europe.

Even so, central banks will remain the indispensable policymakers, able to act far more promptly than finance ministers can through fiscal policy. That will leave markets both vulnerable and influential given the suspicion that if they have a hissy fit the Fed in particular will mount a rescue. Those betting on that presumption have already been richly rewarded in the recovery in stock markets since the start of the year. A few months ago, central banks thought that they could write themselves out of the leading roles, becoming supporting actors instead. Their modesty was premature. They’re back again in the limelight and won’t go away in a hurry.