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The Economy on Edge

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Where the Fed Goes, Other Central Banks May Not Follow

March 20th 2017

$1B US Currency

It has been a busy couple of days for the world's central banks. Since the U.S. Federal Reserve made its decision to hike interest rates, rate announcements have followed from the People's Bank of China, the Bank of Japan, the Swiss National Bank and the Bank of England. This confluence of activity from most of the key guardians of the global economy provides a good opportunity to take stock of where things stand.

The Federal Reserve had telegraphed its intent to raise its benchmark rate well before Wednesday's announcement, so it came as no surprise. In the past few weeks, various Fed governors had conducted a coordinated speaking campaign to prepare the markets, and Friday's report showing strong U.S. jobs numbers removed its last impediment to action. With recent U.S. economic data generally robust, the Fed wants to give itself room to boost rates two or possibly even three more times during the year.

Although the dollar dropped in the wake of the announcement, the hike should buoy the currency in the medium term as the divergence between U.S. interest rates and those of its peers brings money flowing into the United States. Other central banks are thus faced with a choice: Do they track U.S. actions to protect their currencies, or do they stand pat and take their chances?

The People's Bank of China chose the first path. With capital flight already a major issue, the Chinese bank boosted its interbank rate to try to stay as close to U.S. rates as possible. The Bank of Japan, which favors a weaker yen, chose to leave its policy unchanged, no doubt less worried by the prospect of interest rate divergence. The same can also be said for the Swiss and English central banks, which both left their policies unchanged. Switzerland generally faces a perennial struggle to keep a lid on the franc's value, while the United Kingdom is currently attempting to stimulate exports, making it less keen to maintain a strong currency than in recent decades.

Below the surface of the central banks' moves, or lack thereof, lurks the question of inflation. Controlling prices is the sole mission of almost every major central bank (the Fed has a dual mandate that also includes managing unemployment), so inflation numbers are the true drivers that shape monetary policy over time. Following several years in which central banks had to battle deflation, inflation has returned to the developed world over the past 12 months, and this has changed the tendency among central banks from further monetary easing to tightening.

But this inflationary trend appears to rest on weak foundations. The first sign of the turnaround in prices emerged last year in China, where falling commodity prices since 2012 had created an ongoing drop in production prices, which manifested around the world as consumers bought cheaper Chinese products. As commodity prices stabilized last year, driving Chinese production prices up for the first time in four years, they helped create the reflation narrative that seized global markets. (The rises and falls in commodity prices also directly affect each country's inflation figures, not just through China.)

But inflation driven by commodity price increases is less sustainable than that caused by wage pressures. If commodities reverse, the inflationary gains would rapidly evaporate, leaving central banks back where they started at the start of 2016. On March 8, China released figures for February that showed producer prices accelerating at their fastest rate in nearly nine years. But this news came as the Brent oil price was in the midst of a sharp fall, dropping below $51 for the first time since November. Thus, while Chinese price trends still seem strong, their underlying support appears to be somewhat soft.

Meanwhile, the United States continues on a path partly of its own. The U.S. executive branch is committed to actions that would stimulate the economy. It is pushing for tax cuts and increased infrastructure spending — the kinds of policies that would boost wage pressures and make for sustainable inflation. Those ideas face uncertain futures, however. The president and Congress have not yet aligned on what tax reform should look like, for example, but it seems likely that at least some form of corporate tax cut will make it through the legislative process by the end of the year. This, in turn, could influence the Fed to maintain a clear tightening path as the rest of the world comes down off the commodity price bounce and starts to think about loosening monetary policy again.

The last time the world's central banks sharply diverged from the Federal Reserve came after the Fed increased its benchmark interest rate in December 2015, its first increase since 2008 (Wednesday's hike was its third). That divergence led to a two-month period of drama in global financial markets, with sell-offs hammering weak points such as Italian banks and Chinese capital outflows markedly increasing. That period came to an end after central banks apparently coordinated their policies to reduce the divergence. This time around, with strong pressures pushing the actors in different directions, such an alignment would be harder to achieve.


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