#Market Strategy — 18.12.2017

Key Lessons From Central Bank Meetings

Guy Ertz

The Fed, ECB and Bank of England plan to normalise their policy further, but at different speeds.

The Fed: before the meeting

The Fed had already made clear its intention to hike rates at the December meeting. The economy has continued to improve since the last meeting (in October). The latest employment report, business surveys and inflation data all confirm the same trend. The main uncertainty of the Fed meeting was a possible revision of its economic projections (growth, unemployment and inflation), a potential increase in the so-called “Fed dots” (anonymous Fed member projections on the fed fund rate), and a potentially higher-than-expected increase in the target rate at the December meeting.

What the Fed decided

The Fed remained true to itself by not springing any surprises on the markets. Indeed, the decision to increase the target rate by 25bps to 1.50% was bang in line with market expectations. Fed members believe that the likely tax reform will lift GDP growth, albeit only temporarily. They do not think this boost will have a major additional impact on inflation, long-term expectations for economic growth or the target for medium-term interest rates. Indeed, there were no changes to the median “dot“ (expectation of Fed members) for 2018, which suggests three hikes, in line with our expectation. The average 2019 expectation rose a bit, as hawkish members lifted their expectations. The median view remained unchanged. The main change was for the 2020 horizon, with the median dot edging up to 3.1% versus 2.9% in September and a long-term  estimate for neutral rates of 2.75%.

This suggests that due to tax stimulus measures and the fall in unemployment below 4%, the Fed will have to shift its policy into restrictive territory at some stage. Note, however, that there will be a substantial reshuffle of FOMC members in 2018, the Committee’s projections in December could well be revised next year.

We expect the Fed to make three increases next year and none in 2019 as the economy will decelerate. In terms of quantitative monetary policy, the Fed will continue to unwind its balance sheet by reinvesting less in maturing assets. The balance sheet peaked at around $4.5 trillion and has started to decrease very slowly. The normalisation process will take a long time. We keep our 12-month target for the 10-year US Government bond  yield at 2.75%.

The ECB: before the meeting

Economic developments have been on the strong side in recent months. The ECB policy committee was expected to be more confident about taking its  inflation target closer to 2%. A key part of the announcement today concerned the economic forecast and especially whether inflation projections for 2020 would be close to the ECB target.

The ECB decision

As expected, the ECB decided to leave its monetary policy on hold. The general message was still prudent, reiterating that rates would be held low for some time, keeping the option of providing more stimulus if needed. The ECB will not stop bond purchases before September 2018 at the earliest. It will continue reinvesting cash from maturing debt for a longer period. ECB members are more confident about reaching their inflation target and announced an inflation forecast of 1.7% for 2020. This is still below target. We expect the ECB to extend its net asset bond purchasing programme one last time at a reduced pace for the last quarter in 2018 before terminating it. However, the Bank will continue to reinvest maturing assets. We think the ECB will hike the deposit rate in 2Q19, to -0.20% from -0.40%, and will lift it to 0% in late 2019 and raise the refi rate to 0.25%. We stick to our 12-month target for the 10-year German government bond yield of 1%.

The Bank of England (BoE): Before the meeting

Given that the UK and EU have agreed in principle on the three key exit issues of citizens’ rights, the financial settlement and the Irish border came as a pleasant surprise. Note, however, that this agreement postpones the decision about the Irish border and some uncertainty remains. The risk of a disorderly, uncooperative Brexit has faded. The markets reacted positively to the news, suggesting that business and consumer confidence indicators may follow suit over the next month or so. Market participants were quite excited to hear whether the Bank of England would announce any changes to their policy guidance or economic forecasts.

The BoE decision

The BoE decided to leave its monetary policy unchanged. The vote was unanimous. Governor Carney adopted a more positive tone regarding the risk assessment as risks of a hard Brexit have been fading as talks with the EU progress. Business and consumer confidence should move higher, all things being equal. We still think that the Old Lady of Threadneedle Street will not be in a hurry to tighten its policy more in the next few months. The committee will probably wait to have more confirmation that wage growth is accelerating before making a move.

Market reactions

Although these central bank meetings were long-awaited by the markets, the announcements have had no major impact on the markets so far. Yields in the US are roughly back to where they were before the announcement. The dollar is slightly weaker against the euro even if it has bounced back today (Thursday). In Europe, yields moved slightly higher after the ECB revealed its stance. It was the opposite for UK yields. Relative moves between the British pound, the euro and dollar were limited. Equity markets have shown no major change in trend.