In recent years central banks have been acting in unison – unprecedented stimulus and ultra-low interest rates used to guide economies through Covid. As 2022 unfolds the monetary policy of major central banks is beginning to diverge.
The central bank conundrum
The role of central banks varies by country, but all have focus on inflation – a broad-based mandate to maintain stable prices across one’s economy with 2% inflation a common target. To control inflation, central banks must tighten monetary policy and put a hand brake on growth. For some central banks such as the Fed, there’s a dual policy of maintaining full employment which encourages looser monetary policy, relative to sole inflation control.
Indirectly, central banks also worry about acting too soon or aggressively to inflation signals in case they materially harm economic growth. This concern has been at the heart of decision making through 2021 given the drivers of inflation have primarily thought to be from supply constraints. This implies a more transitory inflation that won’t be solved by tighter monetary policy and that higher rates might destroy the delicate growth currently with us. While most economies have recovered, there is much variability by country – some better placed to stomach tighter monetary policy than others. Coupled with marginally different central bank objectives, this is now driving divergence in policy.
Which central bank are where in terms of policy?
The US is experiencing the strongest economic rebound and has clear signs of over-heating, both from inflation, wage and employment data. The Fed has accelerated its tapering of quantitative stimulus and three rate rises are expected this year. Similarly, the Bank of England (BOE) raised rates to 25bp in December. While the UK’s recovery is nowhere near as strong, the BOE has a clear mandate to keep inflation at 2%. With the CPI in excess of 5% there’s pressure to act despite the risk of policy error currently highlighted by the market.
Within the ‘no action’ camp, we have the European Central Bank (ECB) alongside Japan. While Europe is experiencing inflation, there are clear signs of labour market slack implying a more transitory nature to their pressures. Indeed, ECB president Lagarde sees a rate rise as very unlikely and policy is likely to remain accommodative. Similarly, Bank of Japan chair Kuroda has very little incentive to start normalising rates with inflation remaining very low.
Importantly, China stands out in contrast with a loosening policy. The Peoples Bank of China reacted to a property crisis and slowing economy at the end of 2021 by boosting liquidity and guiding lending rates lower. With the Communist party meeting taking place this year to decide on the future its leader Xi Jinping, political stability is their primary objective which means economic growth.
Such divergence of monetary policy highlights the competing drivers for those decisions – economic growth, central bank mandate, and political stability, as well as the concern over the source of inflation and whether or not it’s transitory.
What are the implications for markets?
Divergence of central bank policy can drive asset class returns in various ways. The most explicit is through relative bonds returns. If tightening occurs in the US, then Treasuries should underperform Chinese Government bonds.
Currency often has the most obvious impact. Countries with tighter monetary policy will see currencies strengthen relative to others, currently seen with the US dollar reaching a 5 year high vs the Yen. Within portfolios, the asset classes with exposure to countries with stronger currencies will see a boost in sterling terms compared to those with weaker currencies. Similarly, at a company level the revenues and costs derived overseas will be impacted by these currency moves.
Other asset classes that can be impacted include Emerging Market Debt, particularly with a strengthening dollar. Similarly, commodities priced in dollars usually fall in value when the dollar strengthens.
After a decade of accommodative monetary policy, possibly the largest concern is the impact that rising interest rates and the regional reduction in monetary stimulus will have on asset prices across the board. Perhaps here is where the regional divergence between China and the US will be most acutely felt.
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