Central Bankers Turn More Cautious Than Optimistic

Top officials at the major central banks are signaling cautious optimism about the prospects for their economies.

However, their policies and verbal guidance reflect their caution more than their optimism. That’s because they don’t want to upset what they perceive to be their delicate recoveries.

So long as inflation remains below the bankers’ targets, Melissa and I think that they are likely to continue to reduce monetary policy accommodation at a deliberately slow and steady pace. That’s particularly true for bankers at the Federal Reserve and European Central Bank (ECB). Bankers at the Bank of Japan (BOJ) are likely to maintain their ultra-easy policy while they continue waiting for Godot, i.e. higher inflation.

First, let’s have a look at what the central bankers at the Fed have been up to:

(1) Tolerating a brief inflation overshoot. Two Fed officials, FRB-SF President John Williams and FRB-NY President Bill Dudley, recently said that they wouldn’t mind seeing inflation overshoot the FOMC’s 2.0% target for a while. “Fed’s Williams, Dudley Stress Soft Ceiling on Inflation Goal” is the title of a 5/4 Bloomberg article. Williams’ views now carry more weight since he will become a permanent voter on the FOMC when he replaces Dudley at the FRB-NY in June, as we discussed in our 4/10 Morning Briefing.

Bloomberg quoted Williams stating in a 5/4 CNBC interview that: “I am personally comfortable with the fact that inflation may overshoot that 2.0% for a while.” He added: “The central bank’s emphasis on a ‘symmetric’ target ‘is a signal to say that inflation will sometimes be above, sometimes below, but on average at 2 percent,’” reported Bloomberg. The soon-to-be FRB-NY president reiterated that he thinks of 2.0% as the “mid-point” of expected inflation.

Williams thus confirmed our analysis of the minutes of the FOMC’s March 20-21 meeting. In our 4/16 Morning Briefing, we wrote: “FOMC participants expect that inflation will soon rise as ‘transitory’ factors that had weighed on inflation last year dissipate this year. Furthermore, the stronger economic growth is expected to push inflation up toward the FOMC’s 2.0% objective, according to the minutes. But such an increase is not expected to change the FOMC’s gradual course of raising interest rates. Nor would a temporarily overshoot of the inflation target.” Only if inflation should rise “much faster than expected and stay consistently above 2.0%” would the FOMC consider a “slightly” faster pace of interest-rate increases.

Furthermore, the FOMC used the word “symmetric” twice to describe the Fed’s inflation goal in its 5/2 statement rather than just one time in the 3/21 statement. To us, that emphasizes that the FOMC would be just fine with an overshoot of the inflation target, as long as it isn’t too much for too long.

(2) Aiming for persistent 2% inflation. The FOMC held rates steady at its May meeting, as was widely expected. However, the May FOMC statement featured another notable change from the March statement: The phrase “near-term” was dropped. “Since the fall of 2016, the Fed statement had said: ‘near-term risks to the outlook appear roughly balanced.’ In the new statement … the Fed simply said ‘risks to the outlook appear roughly balanced,’” observed a 5/3 MarketWatch article.

Some speculate that the omission may be an attempt to side-step short-term noise from trade war talk. That’s possible. It is also possible that the Fed is simply more focused on the medium-term for the economy, especially inflation, which officials want to see persist around 2.0%.

The personal consumption expenditures deflator (PCED), one of the Fed’s preferred measures of inflation other than the core PCED, climbed to 2.0% y/y in March. The only other time it was at 2.0% or above since March 2012 was in early 2017 during January (2.0%) and February (2.2) (Fig. 1).

(3) Losing faith in Phillips curve. Most Fed officials seem still to believe in the inverse relationship between inflation and unemployment, i.e., the Phillips curve. Yet several important voting members, including Fed Chairman Jerome Powell, have come around to the idea that the Phillips curve has flattened, i.e., low unemployment may not spur wage or price inflation as high as in the past.

By the end of this year, Fed officials expect the unemployment rate to fall below 4.0% and inflation to nearly touch their 2.0% y/y target, according to the latest Summary of Economic Projections. During April, the unemployment rate dipped below 4.0% for the first time since December 2000. But no alarm bells sounded because the average hourly earnings measure of wage inflation remained tepid, growing just 2.6% y/y, as we discussed yesterday (Fig. 2).

“Falling Unemployment Could Pressure Fed to Move Faster on Rates” was the title of a WSJ article posted online Friday. We disagreed. Then we noticed that the title of the article was toned down for the 5/5 print edition of the WSJ to “Employment Report Could Foreshadow Fed Challenges.” That’s a more agreeable conclusion to us.

(4) Normalizing federal funds rate toward 3%. The federal funds rate is currently targeted at a range of 1.50%-1.75%. Rate hikes during June, September, and December of this year would bring the range up to 2.25%-2.50% by year-end. Melissa and I expect a couple more rate hikes in 2019 to take the range up to 2.75%-3.00%, which is consistent with the latest consensus projections of the FOMC’s participants.

ECB: Draghi Minding His ‘P’s. At the ECB’s 4/26 press conference, President Mario Draghi struck a cautious tone about the bank’s approach to monetary policy. “Effectively, the ECB needs more information before it can engage in a meaningful debate on the next policy move,” noted the head of European economics at BNP Paribas, according to the 4/26 FT. Draghi recognized that the pace of the Eurozone’s recovery had moderated. No changes were made to monetary policy (neither to interest rates nor to the bond-buying program), nor did the bank provide updated guidance.

Draghi’s tone during his April press conference mirrored his attitude on 4/20 when he told finance ministers and central bankers that “the Eurozone’s growth cycle may have peaked” and that the ECB “would move only slowly to phase out its large monetary stimulus,” paraphrased the WSJ. In his own words (with our emphasis), Draghi said: “While our confidence in the inflation outlook has increased, remaining uncertainties still warrant patience, persistence and prudence with regard to monetary policy.”

Here is some more context behind the relatively uneventful press conference:

(1) Eurozone growth slowing? The WSJ article noted that there seems to be a difference of opinion among Draghi and at least one of the 25 members on the ECB’s rate-setting-committee. Jens Weidmann recently said: “There’s no reason to see a turning point in growth—Germany’s economy is still booming.” But of course, as the president of Germany’s central bank, Weidmann is more focused on Germany’s economy than the Eurozone. (By the way, Weidmann is reportedly the favorite to succeed Draghi when his term is up in October 2019, according to a 3/19 Bloomberg article.)

Draghi observed during his April press conference: “When we look at the indicators that showed significant, sharp declines, we see that … this loss of momentum is pretty broad across countries.” During February, industrial production in the Eurozone slid for the third month in a row. There’s also been evidence of softness in the purchasing managers surveys in addition to retail sales and consumer confidence. The 4/18 WSJ observed: “The June gathering is regarded as potentially more significant, and policy makers should by then have some sense of whether the first-quarter slowdown was temporary or lasting.”

A few days before Draghi spoke, on 4/18, Eurostat released the Eurozone’s March inflation rate, which was up 1.3% y/y. Inflation was still a distance from the ECB’s inflation target of below, but close to, 2.0%. The flash estimate of April’s CPI released on 5/3 showed 1.2% y/y. For April, the CPIs in France (1.8% y/y) and Germany (1.4) increased faster than inflation in other major Eurozone countries, while rates in Spain (1.1) and Italy (0.6) weighed on the overall Eurozone inflation statistic (Fig. 3).

(2) No change in pace of bond buying. It is expected that an interest-rate increase by the ECB won’t be on the table until early to mid-2019. The ECB has planned first to start unwinding its asset purchase program (APP). During March of this year, the ECB dropped its pledge to buy more bonds in the event of a future recession, reported the FT, signaling a shift in the bank’s “easing bias.”

Prior to that, there had been no action on the APP since October 2017, when the ECB announced a further reduction starting in January 2018 to a monthly pace of €30 billion until the end of September 2018, “or beyond, if necessary.” (See our Chronology of ECB Monetary Policy Actions.)

Back in December 2016, the ECB announced that it would reduce its purchases under its APP from the monthly pace of €80 billion to €60 billion, starting in April 2017 and until the end of December 2017, “or beyond, if necessary.” The monthly purchases under the APP had first been set to €80 billion starting in April 2016. Since then, the ECB’s assets have grown from €2.90 trillion to €4.55 trillion (Fig. 4).

(3) Rising trade risks. By the way, ECB policymakers are also waiting to see how the trade spats between the US and Europe and the US and China pan out. During his April presser, Draghi warned: “If we have an increase in tariffs, increase in protectionism, there may be direct effects, trade related effects. … They don't seem to be substantial. However we don't know the extent of the retaliation yet. … What is certainly known is that these events have a profound and rapid effect on confidence, on business confidence, on exporters' confidence generally speaking. Confidence can in turn affect the growth outlook. This is why we say there are risks.”

BOJ: Kuroda’s Long-Lasting Last Stand. Like the ECB and the Fed, the BOJ is patiently waiting for 2.0% inflation to arrive and stick around for a while. But it might have a long wait. On 4/28, in its April Outlook for Economic Activity and Prices, the BOJ ditched its ETA for reaching its inflation target. Here are the details:

(1) How do you say “mañana” in Japanese? In its January Outlook for Economic Activity and Prices, the central bank had projected it would meet its 2.0% target for consumer price inflation by “around fiscal 2019.” Prior to letting go of a target timeframe altogether, the BOJ had pushed out that date six times, most recently until March 2020, observed the 4/27 WSJ. Nevertheless, the BOJ’s April report explained: “Although it is necessary to carefully examine the fact that firms’ wage- and price-setting stance has remained cautious, the momentum toward achieving the price stability target of 2 percent appears to be maintained.”

The WSJ recalled that the BOJ’s Governor Haruhiko Kuroda “offered a target date shortly after taking office in 2013, saying he thought inflation would hit 2% within two years.” The BOJ’s preferred measure of inflation is the CPI for all items less fresh food, or the “observed CPI.” During March, this rate increased 0.9% y/y (Fig. 5). It’s not for the BOJ’s lack of trying. Since the beginning of 2013, the BOJ’s total assets increased from ¥158 trillion to ¥535 trillion (Fig. 6).

(2) No change until further notice. Nevertheless, Kuroda said at his news conference: “Our policy commitment hasn’t changed at all.” He added: “There is no change in our stance that we will persistently continue aggressive easing.” Reuters reported that “Kuroda noted the omission of a target timeframe was aimed at preventing markets from betting on additional easing each time the BOJ pushed back the timing for hitting its price goal.”