Central banks face up to new era in UK and US

The implementation of a negative interest rate policy by the Bank of Japan at the start of the year was followed in March by further easing from the European Central Bank (ECB) that saw interest rates cut to zero per cent, the deposit rate slip further into negative territory at -0.4 per cent, and an expansion in its bond-buying programme to include high-quality corporate bonds. 

In the wake of the Brexit vote in June, the Bank of England (BoE) acted to pre-empt a decline in the UK economy by cutting the base rate to 0.25 per cent, and extending its quantitative easing (QE) programme by adding an additional £60bn to its government bond purchases and introducing a £10bn UK corporate bond-buying initiative.  

Alex Dryden, global market strategist at JPMorgan Asset Management, says: “The Monetary Policy Committee sprang into action in the summer by restarting QE and cutting interest rates to help cushion the blow of Brexit. Markets were initially pricing in further cuts by the end of 2016, but surprisingly strong economic data out of the UK has meant that the BoE has been able to keep its powder dry and it has left monetary policy unchanged since the summer. However, this does not mean the UK economy is out of the woods just yet.

“The impact of the sharp fall in the pound and the rebound in oil prices is likely to see inflation reach 4 per cent in 2017, while economic growth slows as investment in the UK begins to dry up. It is likely that in this environment the BoE will continue to keep monetary policy loose for fear of hurting a vulnerable domestic economy, despite inflation being above the 2 per cent policy target. With these headwinds in mind, it is no surprise that the market is forecasting it will take five years for the BoE to raise interest rates by 1 per cent.”

But while the UK appears to be continuing along the ‘lower-for-longer’ interest rate approach, the surprise election of Donald Trump may have a different impact on investment and economic policy. 

The US Federal Reserve has so far held off from enacting a rate rise this year, but in the wake of the election result and the prospect of increased infrastructure spending, some experts suggest a December rate hike is inevitable. 

David Roberts, head of fixed income at Kames Capital, points out that since the result government bonds have sold-off along with riskier debt on expectations that Mr Trump’s package of tax cuts and infrastructure and defence spending will lead to higher inflation, and thus a less-accommodative central bank.

He explains: “There are some questions we don’t yet know the answer to. Does [Janet] Yellen believe Mr Trump will ease policy? What kind of response are we going to get from her? How long will she even be around for? But with full employment and some inflation pressure, we think there could be another 1 per cent on US interest rates over the next 18 months. If Ms Yellen believes Mr Trump will spend $5trn [£4trn] on policies that make a difference, then bonds have further to sell off.”

But with some central banks continuing along the path of easing and others looking to hike rates to combat growing inflation, the diverging approaches raise the question of whether the unorthodox methods have worked, or if central banks are finally reaching the limit of their tools? 

James Inglis-Jones, co-manager on the Liontrust European Growth fund, says: “This year has seen a number of landmark monetary policy decisions taken, but one key difference with previous years has been the way in which markets have reacted. Investors had previously responded to expansionary policies from the ECB and other central banks by seeking risk, bidding up the prices of cheap assets with contrarian value appeal in a ‘dash for trash’. But this effect was much less marked in 2016. Monetary policy seems to have become less effective in stoking investors’ animal spirits. Instead, the potential for new fiscal policy measures is coming to the fore, particularly following Mr Trump’s surprise election victory. 

“This shift away from an over-reliance on easy money and hugely accommodative central bankers is a big positive for UK investors; 2016 may have marked a turning point.”

Nyree Stewart is features editor at Investment Adviser