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The fitful global economic recovery, and the uncertainties it has spawned about the outlook, have caused central banks to question how monetary policy should respond. The long established notion that monetary policy works with long and variable lags, and therefore should be applied pre-emptively, seems to have fallen out of favour with central banks. Instead, most central banks have become dedicated data watchers to help determine when to adjust monetary policy. Given that there are always lags gathering and publishing economic data and some economic readings, such as employment and unemployment, are known to lag changes in economic growth, the central banks penchant for data watching risks monetary policy changes that occur far too late to affect economic conditions in the way that policymakers desire.
In the case of the US Federal Reserve (Fed), recent comments from senior officials and including the minutes of the most recent March FOMC meeting, all point to the importance of watching US economic readings and how their relative strength or weakness tallies with the Fed’s policy objectives – sustainable economic growth with annual inflation around 2%. US non-farm payrolls have been rising strongly over the past year or so and the unemployment rate has fallen to 5.5%, a level that in the past would be considered to be approaching functional full-employment and likely to lead to increasing inflation over time. Other US economic readings, however, are more mixed strength and even labour market indicators are not consistently strong, with wages growth still subdued in aggregate although the large majority of the US are talking of lifting wages.
If the Fed was operating pre-emptively it would probably already have two interest rate hikes under its belt. The data-watching Fed, however, will probably not be sufficiently convinced that US economic growth is sustainably strong until late 2015, possibly even early 2016.
One consequence of delaying the start of normalising US interest rates, we believe, is that financial asset prices run stronger for longer and the degree of over-valuation in asset prices becomes even more pronounced. It also seems fair to assume that when asset prices eventually turn down, the risk of a larger and more disorderly fall than usual is high. The key problem that investors face is that it is difficult to determine how much longer the run up in asset prices will last. In the past, it has not been the first interest rate hike that causes asset markets to turn lower, but more often the third or fourth hike. With a cautious, data-watching Fed it could easily be the second half of next year before the third interest rate hike is delivered.
Another problem assessing what might happen to investment asset prices is that the US Fed is a rarity in that it is approaching a decision to start hiking rates. Almost everywhere else, central banks are still in the business of easing monetary policy, but where they are acting in common with the Fed is that they have become dedicated data watchers to determine when they should act.
It took evidence of deflation in Europe before the European Central Bank announced its more aggressive quantitative easing program in February. Similarly, it took a run of economic readings consistent with fading economic growth and rising unemployment before the RBA decided to cut the cash rate back in February by 25bps to 2.25%. In the past, when the RBA has become convinced that the economic outlook is changing it has usually delivered rate moves in quick succession on the entirely reasonable premise that if there is cause to change policy, it is best to act rapidly given the delays before policy change impacts.
The current RBA rate cutting cycle is turning out to be a slow and drawn out affair. At both the March and April policy meetings, when the RBA decided to leave the cash rate unchanged, the accompanying statement concluded that “further easing of policy may be appropriate over the period ahead, in order to foster sustainable growth in demand and inflation consistent with target”. In other words, the RBA has it in mind that more interest rate cuts are needed, but wants the evidence that growth and inflation are running – and are likely to continue running – too low.
Cutting rates slowly and belatedly in an economy losing momentum looks like a recipe for persistently low and falling Australian interest rates for many months to come. Australian financial asset prices look set to become increasingly over-valued. While it is possible that the eventual topping out in US asset prices will set the scene for asset prices to top out elsewhere internationally it is also possible that asset prices may march to their own tune elsewhere for a period. On the basis of the Australian interest rate outlook in isolation, Australian asset prices could bubble along through 2015 and much of 2016 too, but at some point a down-turn will come and it is likely to be very pronounced in our view.