TalkingEconomics: Central bank hawks, low inflation and balance sheet reduction

Low inflation is harrying the hawks, and is keeping the Fed cautious as it looks to reduce its balance sheet.

2 August 2017

Keith Wade

Keith Wade

Chief Economist & Strategist

    Central bankers have taken a more hawkish tone, questioning the level of policy accommodation given the recovery in the world economy. That said, low inflation presents a challenge.

    We expect the Federal Reserve (Fed) to proceed cautiously with its balance sheet reduction and, given low inflation, we now see little likelihood of further rate rises this year.

Against a backdrop of a normalising global economy, central bankers have begun to flag a move back to more normal interest rates, causing bond yields to rise. However, inflation has surprised to the downside in both the developing and the developed world. The softening of oil prices has played a part in this, but so too has a decline in core inflation (consumer price inflation excluding food and energy).  In the US particularly, we would draw attention to the effect of technology in the retail sector where technological innovation (for example the rise of Amazon) brings new competition and creates dislocation and deflation for incumbent firms.

Such effects are expected to persist and, looking ahead, year-on-year inflation rates should head lower in the second half of this year and into next. That said, on a quarter-on-quarter basis we still expect to see a stabilisation and gradual pick-up in inflation. In the near term though, low headline inflation may well cause the more hawkish central bankers to pause for thought as they consider normalisation and a new dawn of higher interest rates.

Fed balance sheet reduction: does it matter?

For the Fed, the rate call is complicated by the decision to start slimming down its balance sheet, which will remove an important source of market liquidity. The concern is that this could lead to a sharp rise in bond yields with the result that financial conditions inadvertently tighten.

At present, financial markets are quite sanguine on the prospect of Fed balance sheet reduction. We would not wish to be alarmist, but it has to be said that we are in unchartered territory. Periods where the Fed announced changes to its quantitative easing programme have been associated with market volatility such as the taper tantrum of 2013. The Fed has not said where it sees the balance sheet ending up; it will be somewhere below today and above its pre-financial crisis level. Forward-looking markets could well take alarm at the impending step-up in the run-off process and move well before the Fed gets to its second year of reduction. Consequently, a spike in bond yields might not be the low risk event that many anticipate. 

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