During a couple of months, all seemed quiet on the monetary front. This was more a coincidence rather than a fundamental change and the remainder of the year should see a renewed focus on monetary divergence between the US, the Eurozone and Japan.
William De Vijlder analyses today's economic situation and considers the possible implications for the long run.
Since about three months, the market nervousness of the early part of the year has given way to a more relaxed attitude of analysts and investors alike. Explanations are the significant rebound in oil prices, which has brought relief for commodity exporting countries and for the energy sector, and better economic data in China on the back of huge stimulus efforts. Monetary factors have also played a role. The turmoil created by the surprise decision of the Bank of Japan to introduce negative deposit rates was followed by a calmer environment when the ECB decided to extend the scope of its asset purchase programme whilst limiting the additional reduction of its deposit rate. In addition, the Federal Reserve was adopting a very cautious stance. Some observers even considered this to be manifestation of an international policy coordination effort within the G20. In reality it was more of a happy coincidence with the BoJ and ECB taking a pause after their latest moves and a Federal Reserve which was concerned about the impact of global risks and uncertainties on the US.
This will change in coming weeks and months. Several Federal Reserve officials have adopted a more hawkish tone as of late and Janet Yellen has expressed a keenness to hike policy rates if data continue to improve sufficiently. In Japan we expect the central bank to lower the deposit rate further. The main objective here is to avoid that, by doing nothing, the yen would strengthen. Yen appreciation would drive inflation further away from the BoJ's objective and would also be detrimental to the stock market and hence confidence of households and corporates. A more expansionary policy by the BoJ would go hand in hand with new fiscal policy stimulus which we expect from the government. Finally the ECB is widely expected to come with new measures in the fall. We, like many market observers, expect an announcement that the QE programme will continue well beyond March 2017. Core inflation will be very slow to pick up so extending the programme is a necessity. Moreover, a decision not to continue would create significant nervousness in currency and bond markets.
Bringing this all together, monetary divergence, which has been stable in recent months, is set to increase again. Quite obviously, this should have an impact on exchange rates as already illustrated by dollar strengthening following recent statements by Janet Yellen hinting towards policy tightening. The BoJ and the ECB will welcome Fed action because the ensuing currency impact is in line with their own policy objective, i. e. more inflation. The key question however is whether there will be broader repercussions. The discussion three years ago about tapering and the concern about the first hike which dominated the second part of last year are reminiscent of how much emerging market sentiment is dependent upon the outlook for US rates. Yet, the Fed has been so cautious in preparing for a new hike, which at the time of writing is not a done deal yet, that in case there was a hike, it would raise the hurdle for and hence reduce the likelihood of additional hikes. All in all this should limit nervousness about possible actions of the Federal Open Market Committee.
"(...) monetary divergence, which has been stable in recent months, is set to increase again."