The drip-feed of high frequency economic data from the major economies slows in the week ahead. The data that is reported is unlikely to have much impact on the expectations of policy going forward.
The state of play is fairly straightforward. The Federal Reserve is finding it difficult to take the next step in the normalization of monetary policy. According to Bloomberg calculations, the Fed funds futures strip does not show greater than a 42% chance of a rate hike at any meeting through the end of next year.
The BOJ and the ECB have signaled a review of their respective monetary stances next month. Neither the BOJ’s increased equity purchases and new dollar lending facility (which could be more important due to changes in the US money markets that impact dollar funding), nor the “fresh water†in Abe’s fiscal plans have impressed investors. There is some speculation that BOJ Governor Kuroda may abandon the 2% inflation target.
We have argued that the target is on the wrong inflation measure (CPI excluding fresh food), and the timeframe was too ambitious. It should be a medium-term target or goal. Making it short-term, and the repeated moving it further out, undermines the very credibility and transparency that an inflation target theoretically enhances.
The ECB staff will offer updated forecasts next month. There are two areas that many investors expect action.
First, following the staff forecasts, it will be clear that officials cannot be confident that its inflation target will be approached. Eurozone fiscal policy became a little easier this year as ostensibly to cope with the refugee challenge. It is anticipated to be somewhat less accommodative next year. The 80 bln euro a month of asset purchases may be extended from March until September 2017. This would be the second extension.
Second, the extension of the asset purchases may aggravate the shortage of some securities in the eurozone. Some speculate that the capital key (a function of size of the economy) as the determining mechanism of how the 80 bln euro in asset purchases is distributed among the member may be abandoned. We demur. There are a number of other adjustments that can be made, and we see the capital key as an important principle that is unlikely to be easily eschewed.
When the Fed was engaged in asset purchases, before the ECB or BOJ initiated their program, a popular chart showed the size of the respective balance sheets. It seemed to show that the expansion of the Fed’s balance sheet was weighing the dollar. We were skeptical. Over the past year, the ECB and BOJ’s balance sheets have expanded by nearly 50%, while the Fed’s balance sheet has contracted by 5%. During the period, the yen has appreciated by over 22%, while the euro has risen 1.6% against the dollar. On a real broad trade-weighted basis, which is the most relevant economic measure, is about 3% higher over the past year.
The Fed’s hesitancy in lifting rates is not due to the dollar any more. At first, policymakers were thrown off balance by the shockingly poor May employment report. We argued at the time that a statistical quirk was not uncommon; taking place once a year or so. Of course, confidence in this assessment was only possible because the June and July employment data. The two-month average stands at 274k, which is the highest this year, and above all but two months last year.
