Just about everyone expects the Federal Open Market Committee (FOMC) to raise its target interest rate at its meeting this week. The talk of raising rates has occupied newspaper columns all year, and the comments from FOMC participants have become stronger in recent months in discussing their desire to raise rates. But the decision to raise rates won’t have come about because of any strong economic data, be it inflation hovering around the Fed’s target or the low unemployment rate showing strength in the labor market. Labor market activity has been relatively steady all year and there haven’t been any surprisingly strong signs of economic growth, so why the green light now?
Because the European Central Bank (ECB) announced at its meeting last week that it would extend but taper its bond purchases.
In the aftermath of the financial crisis, one central bank after another engaged in quantitative easing. The Federal Reserve, Bank of England, ECB, and Bank of Japan all engaged in large-scale asset purchases in attempts to drive down interest rates, remove overvalued assets from bank balance sheets, and attempt to jump-start their economies. Various interest rate targets were driven to near-zero, and even negative in Japan and Europe. Central bankers eventually realized that they couldn’t maintain those levels of policy accommodation indefinitely. But no one wanted to be the first one to start tightening. The fear was that if a central bank began to tighten policy while other central banks didn’t, the first country’s tighter policies would cause its economy to slow down, harming its relative position vis-a-vis other major countries. No central bank wanted to take the blame for weakening its country’s economy. So month after month, meeting after meeting, central banks just held pat.
Fast forward to last week, when the ECB announced its tapering. That was a signal to other central banks that (relative) tightening could commence. The ECB’s move signaled that it was open to tightening its policy accommodation, and now the ECB will be waiting to see how other central banks respond. The FOMC releases its decision on Wednesday, the Bank of England on Thursday, and the Bank of Japan early next week. The expectation is that the Fed at the FOMC meeting will hike its target funds rate this week, most likely to 0.50-0.75%. Once we see the Fed raise rates, we’ll have to wait and see what the Bank of England and Bank of Japan do. That should give us an indication as to whether this coy public signaling between the ECB and the Fed is just a bilateral move or an attempt to get other countries to agree to tighten in conjuction with them, or if there has been some major behind-the-scenes negotiating among the four central banks to coordinate a rise in target rates.
The Bank of England may be the least likely to tighten, as their last loosening took place in August, post-Brexit. Japan’s economy also has been foundering for years, and Governor Haruhiko Kuroda has consistently stated that he will pursue further monetary easing to force Japan’s inflation rate to two percent. The three possibilities then that we are facing this week are:
- ECB and Fed signal tightening, as do BOE and BOJ. This would indicate some level of negotiation behind the scenes among the four major central banks. Any future moves could then be assumed to be coordinated, so that if one central bank tightens again, the others will do so too.
- ECB and Fed signal tightening, BOE and BOJ do not. The most likely scenario. Kuroda may view the ECB and Fed announcements as being equivalent to a rate cut in Japan, and might hold steady until he can view the effects on the Japanese economy. Barring any shocks, any additional tightening or announcements of future tightening on the Fed’s part would probably take place no sooner than next spring.
- ECB and Fed signal tightening, BOE does not, BOJ loosens. Probably the second-most likely scenario. The BOJ loosening would put a lot of pressure on the ECB, BOE, and Fed. Any tightening by those three would likely be put off for at least six months until the effects of the BOJ’s loosening could be determined. A large enough BOJ monetary easing might even short-circuit ECB and Fed monetary tightening plans for the coming year.
Stay tuned for the next week to see which direction the world’s central bankers decide to take us.