Central bank competence is essential for the smooth functioning of modern-day economies and the task they have isn’t easy. Bank leaders have a tough job judging the right level of interest rates and when to intervene to sustain growth, maintain employment and control inflation. Criticism of their actions is never far from the financial media headlines.
In the US and the UK each central bank operates independently of the government. This is important today, but it hasn’t always been the case here in the UK. The Bank of England only gained independence in 1997 after being granted this privilege by Parliament. The Federal Reserve Bank (Fed) has, however, been acting independently since 1913; albeit subject to oversight by Congress.
The Fed’s independence has never been questioned quite like it has in recent times. This comes after several statements from President Donald Trump calling for the Fed to cut interest rates. For Trump it is a simple matter. He wants to encourage more growth in the economy knowing this will get him re-elected in 2020. It is a little more complicated for the Fed as they want to sustain growth for as long as possible rather than turbo charge it. However, they have recently turned more dovish signalling that rates are more likely to move down than up.
Last week, three of the world’s major central banks, the US Federal Reserve (Fed), the European Central Bank (ECB) and the Bank of England (BoE) issued their latest readings, each providing an outlook. In general terms they are taking a close look at hard data, trying to interpret how the economy has performed and how this might impact their decisions going forward.
In the previous edition of ‘Beyond the Headlines’ we focused on the Fed. This week we shine a spotlight on the ECB and BoE.
ECB
One of the key roles of any central bank is to aim for a stable level of inflation. Since the financial crash central banks have worried a lot about the lack of inflation. This is a sign that growth, generally, is too weak, hence central banks like the ECB have been keen to set a target rate for inflation; mildly positive at 2%.
The ECB, like other central banks who also target inflation, recognise the importance of doing so. In Europe inflation has been muted, as demonstrated in the chart below. This is a problem that needs to be solved because if prices begin to fall individuals start to adjust their spending by holding back purchases. If this becomes widespread behaviour it can create a downward spiral.
Eurozone Inflation vs GDP Growth
Source: Bloomberg, June 2019
At the ECB’s annual symposium, president Mario Draghi, stated that the ECB may require a fresh phase of its quantitative easing (QE) programme. As a quick reminder, QE is a form of unconventional monetary policy where a central bank injects capital into an economy via the purchasing of instruments like government debt (bonds). This causes yields to fall, lowering the cost of borrowing.
Following the financial crisis of 2008-09 the ECB applied QE and lowered interest rates. This is clear from the chart below.
ECB post-financial crisis monetary policy
Source: Bloomberg, June 2019
With significant injections of QE, the ECB managed to drive bond yields lower and stimulate growth but they are struggling to hit their 2% inflation target, as measured by CPI. Moreover, inflation has started to drop again.
ECB QE Stimulus vs Eurozone Inflation
Source: Bloomberg, June 2019
Draghi’s comments about the need for yet more stimulus comes at a time when global economic growth has slowed. Growth in Europe is now described as being a bit like the curate’s egg – partly bad but also partly good. The bad part is a lack of growth across the industrial and manufacturing sector. The good part is the services sector where growth remains resilient.
Recently we have highlighted strong job creation in the US and UK which is also improving markedly across Europe. Mario Draghi and other political leaders want even lower EU unemployment because, although improving, it is still higher than in the UK and the US. Draghi recognises that a boost now may be just what is needed to get the economy firing on all cylinders, especially if European government leaders re-appraise their fiscal policies to inject more money into the economy by way of investment.
BoE
While the ECB is looking at restarting its use of QE, the Bank of England sits in a more precarious position in terms of deciding what to do next.
Since the last BoE meeting global trade tensions, mainly between the US and China, have increased. The UK economy has also had to contemplate what a future trading relationship will look like with Europe and beyond in a post Brexit world. Thankfully the worries generated have not been nearly as damaging for the whole economy as forecast by the BoE, but one area that has taken the warnings more seriously is business itself. This is reflected in business sentiment surveys such as the one below which shows confidence faltering. The lack of certainty and low confidence is thought to be holding back investment.
Sentiment of European, US and UK Businesses
Source: Bloomberg, June 2019
Looking ahead, the BoE has altered its own economic growth forecasts, with the expectation that growth will drop to 0% in the second quarter, commenting that “underlying growth in the UK appears to have weakened slightly in the first half of the year relative to 2018 to a rate a little below its potential”.
Mark Carney, BoE governor, faces a hurdle that no other governor has faced before; Brexit. The Monetary Policy Committee (MPC) is fully aware of the risks this poses to the UK economy but have struggled to offer any sense of opportunity that may arise. The MPC has always stated that interest rates could either rise or fall if we saw a no deal Brexit and the movement of rates would be dependant upon supply, demand and the exchange rate. This is code for – We will react to whatever comes our way.
The lack of visibility around the outcome of Brexit increases the difficulty of forecasting what the future of the economy will look like, which makes setting forward looking policy a challenge. There is a strong sense that unblocking the Brexit impasse will unleash pent up investment and this will restart the economy in a positive way. We are also hearing of new policy initiatives from politicians around spending and tax cuts which, if enacted, will boost growth. This offers a great opportunity for potential to be unleashed not just by business but by human capital taking a more optimistic view of the future.
Conclusion
The overall consensus view coming out of central banks is that the US-China trade dispute is having a detrimental impact on global growth which has slowed relative to 2018. However, central banks are reminding us that they have many tools in their war chest to combat faltering growth; whether this involves cutting interest rates, as the markets expect, or reintroducing QE which the ECB has hinted at.
The BoE remains in a different position to the rest of the other major central banks. The Fed and the ECB have suggested interest rates may be cut whereas the BoE is on hold, for now.
Finally, over the next few days the leaders of the world’s major nations, the so-called group of 20, will also be gathering to discuss future relationships. Going into the meeting expectations are not set high. This isn’t necessarily a bad thing because low expectations are easier to beat and who knows we may get some positive surprises.
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