The Limits to Monetary Policy

James Ashley

Despite years of monetary policy intervention, global economic growth remains sluggish.

The Bank of Japan last month pushed back the frontiers for global monetary policy, demonstrating once again that its policymakers have little fear of experimental innovation.

The recent BOJ announcement not only aspires to an intentional, temporary overshooting of the inflation target, but also sets out an explicit target for long-term rates, expressed via 10-year Japanese government bond yields.

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This marks a potentially momentous milestone for investors, as central banks are again being forced to delve into ever-more esoteric and untested parts of their toolkit.

Large swathes of the world continue to face shortfalls in nominal demand. Inflation expectations are well below target, and credit flows to the real economy in many countries are anaemic.

Yet the outlook is not unremittingly bleak, in my opinion. In particular, we would point to the US economic recovery as a cause for moderate optimism.

We view the US labour market as solid, slack in the broader economy as limited, and consequently we see inflationary pressures -- with the core US consumer price index above 2 per cent for the ninth straight month in July -- starting to build. 

As a result, we believe monetary policies around the world are now likely to head in divergent directions. After a 35-year bond bull market run, the US has reached an inflection point, even as there is much uncertainty around the pace of policy normalisation.

Elsewhere, particularly in Europe and Japan, accommodative monetary policy continues in an effort to reflate the economy.

The trouble we see with a continuation of extraordinary monetary policy in Europe and Japan is that there is a slowly diminishing set of viable policy options left available to central bankers, with market perceptions of these policies’ efficacy also diminishing. A shift towards a more supportive fiscal policy in certain economies strikes us as the logical next step. 

From an investment perspective, we think the impact of widening interest rate differentials creates a case for dynamism in the face of changes in relative value. Not only do absolute interest rate levels (positive or negative) affect investment performance, but so do market expectations.

Although the market’s estimate since the UK’s Brexit vote of a low probability of further rate hikes from the Federal Reserve (Fed) during 2016 seems reasonable, we believe adjustments towards higher yields would more likely occur at the longer end of the curve.

Outside the US, we think the European Central Bank and Bank of England could still cut rates further if needed. Those moves would be important not only for rate markets but also for foreign exchange.