Markets: it's business as usual for central banks. Bond markets have responded to the change in outlook by gradually shifting towards pricing in more hikes (in the short end) and lifting yields (in the belly of the curve and the long end), thus expecting central banks to respond to the outlook the way they have always done - by hiking rates pre-emptively, to nip any increase in inflation expectations in the bud. That is, markets seem to believe that central banks' reaction functions have remained virtually unchanged.
The reaction function has changed: rational inaction. By contrast, we think that the major developed economies' central banks' reaction function has changed meaningfully with the crisis and the landscape it generated. We think, in the short term, that central banks' strategy will be one of rational inaction, as a number of considerations will make it preferable to stay on hold:
• Financial stability concerns will make meaningful tightening difficult, as banking systems and consumer balance sheets are still fragile and highly indebted sovereigns live with the threat of bond market retaliation.
• Reduced visibility because the bumpy, below-par and brittle (BBB) economic recovery implies that it is better not to act. Put differently, given that inflation is the lesser evil - compared to the risk of a double-dip and/or deflation - we think that central banks will be inclined to act in a way that makes inflation, rather than deflation, more likely (see The Global Monetary Analyst: Better the Devil You Know, August 18, 2010).
• Moreover, central bankers have for some time repeated that they, and we, face an unusual level of ‘Knightian uncertainty' - a type of uncertainty for which there is no underlying probability distribution. To be proactive, central bankers need a reasonable degree of certainty as to the economic forces at work and their eventual effect on inflation. Without such reasonable certainty, they may be condemned to being reactive and thus wait until the fog dissipates before they act in a meaningful manner.
In short, we believe that rational inaction means that the major central banks will be on hold for longer than markets expect, even in the face of heightened upside risks to inflation.
Fed, ECB and BoJ firmly on hold. In fact, we see neither the Fed nor the ECB nor the Bank of Japan hiking official interest rates this year. In Japan, our Bank of Japan watcher Takehiro Sato even expects further monetary accommodation through the enlargement of the asset purchase programme, which could happen as early as March 2011. In the US, where our team sees core inflation bottoming and gradually picking up later this year, the Fed will probably not renew the current bond purchase programme when it expires in June, but should keep rates on hold until early 2012 despite the solid average 4% GDP growth that our team is projecting through this year. And in the euro area, our ECB watcher Elga Bartsch thinks markets read too much into Trichet's hawkish comments at the January press conference and expects the ECB to remain on hold throughout this year. Even though it is possible to separate interest rate policy (geared towards the maintenance of price stability) and liquidity policy (geared towards supporting the banking system and thus safeguarding the monetary transmission mechanism), we doubt that the ECB would dare to raise interest rates and thus funding costs for pressurised banks and sovereigns as long as the debt crisis lasts.
Bank of England between a rock and a hard place. Meanwhile, the Bank of England continues to be closer to a rate hike than the other three central banks we discuss. As today's MPC minutes show, a second of the nine members, Martin Weale, joined Andrew Sentance in voting for a hike at the January meeting. However, since the meeting, 4Q GDP surprised massively on the downside earlier this week and Governor King in a speech last night made it clear that the BoE was willing to look through this year's inflation spike provided that wages don't accelerate in the course of this year. Our BoE watcher Melanie Baker thinks that inflation expectations will rise further this year and therefore continues to look for a first rate hike in August.
The rising tide that lifts all boats. But back to the big picture. During the Great Recession, developed economies' central banks slashed rates aggressively; many of them - most notably the Fed, the ECB, the Bank of England and, to a lesser extent, the Bank of Japan - added unconventional measures to the mix when additional stimulus was needed. (Commodity prices, too, are likely to have received a lift from monetary policy since low real interest rates not only stimulated global growth, but also spurred inflation expectations.) The major central banks' super-expansionary monetary policy stance was then imported by emerging economies such as China and others, whose central banks are reluctant to allow (too fast) an appreciation of their currencies against the dollar. Indeed, EM central banks continue to tread cautiously, even in the face of disappearing slack in the domestic economy and the presence of elevated food and energy quotes. Hence, they are unlikely to tighten appreciably in the near future (see The Global Monetary Analyst: "No, Minister", January 19, 2011) - or allow their currencies to strengthen significantly.
Inflation re-export. Import prices in developed economies have already increased somewhat, and anecdotal evidence suggests that the prices for imports from China and other emerging economies are poised to increase further due to higher local inflation. In short, having imported inflation from developed economies through the monetary channel, the emerging economies are now re-exporting inflation to the developed economies through more expensive goods shipments.
Putting together the pieces: the global inflation merry-go-round. In turn, central banks in the major developed economies are likely to accommodate imported inflation arising from dearer commodities and other imports. They are, again, rationally inactive due to financial stability concerns, low visibility on the economic recovery and ‘Knightian uncertainty'.
However, this rational inactivity also makes it more likely that elevated imported inflation ultimately enters inflation expectations and ignites a wage-price spiral. To summarise the global inflation merry-go-round:
1. Super-expansionary monetary policy in the major developed economies is imported by emerging economies' central banks through (US dollar) soft and hard pegs.
2. Having gained a toehold in EM, inflation is re-exported into developed economies through more expensive goods exports.
3. Rationally inactive central banks in developed economies accommodate this imported inflation, ultimately risking a domestic inflation take-off.
Note that this global inflation loop will remain operational until one of the two sides decides to normalise its monetary (or exchange rate) policy. Whether this will happen in time to prevent the global inflation merry-go-round from becoming an upward spiral remains to be seen.
The wrong kind of inflation? We have long been of the view that central banks in the major developed economies will likely generate, or at least acquiesce to, some inflation - given the backdrop of a shallow recovery, lower trend output growth in the medium term as well as high public and private debt levels (see The Global Monetary Analyst: Debtflation Temptation, March 31, 2010). Having inflation arise from external sources would, however, be the wrong kind of inflation. More expensive imports mean a reduction in disposable income for households and in profits for companies - hardly helping overlevered public and private sectors. However, with imported inflation pushing inflation expectations higher and central banks unwilling or unable to respond to the rise in non-core inflation, the chances are that domestic wages and inflation will also pick up eventually.
The global inflation merry-go-round has few takers among central banks in the smaller G10 economies. Here, the picture is as diverse as the economies themselves, though the common element is that public balance sheets are generally healthy. This removes one important constraint on central bank action. In addition, commodity producers benefit from the shift in commodity prices, which lifts domestic production and income. For that very reason, they certainly don't face the problem of having the wrong kind of inflation - any price pressures will emerge from an overheating domestic economy.
Australia: Our RBA watcher Gerard Minack expects Australia's central bank to hike once more by the end of 1Q11 but then to stay on hold for the remainder of the year. The hike is earlier than the market expects, although the terminal rate of 5.00% is roughly in line with market expectations.
Canada: Yilin Nie and David Cho think that the BoC is comfortable with more tightening; they are looking for an above-market terminal rate of 2.00% for this year.
New Zealand: Manoj Pradhan expects the RBNZ to lift rates again in the second quarter and expects a total of 75bp by year-end. His year-end target of 3.75% is somewhat higher than the market expects.
Norway: Spyros Andreopoulos thinks Norges Bank will resume its hiking cycle at the May meeting; this is somewhat earlier than market expectations, though our year-end target of 2.50% for the main policy rate is in line with market expectations. We see risks as skewed towards a later hike.
Switzerland: The SNB is unlikely to take its focus off the EURCHF exchange rate, in our view; we think that its monetary policy will shadow the ECB, not hiking before 1Q12. The market seems to be pricing about one hike by the end of the year.
Sweden: Sweden's impressive economic performance has Riksbank watcher Elga Bartsch looking for 125bp of hikes for a terminal rate of 2.50% by the end of the year. Although the market has gradually moved to price in more hikes, it is still below our own expectation.
The first Inflation Report of 2011 was designed to address various questions of central bank watchers and investors who had difficulty in figuring out exactly what the CBT was trying to achieve with its fairly creative (if not experimental) monetary policy stance (see Turkey Economics: If it Ain't Broke, Don't Fix it: CBT Watch, December 15, 2010). The Inflation Report clearly states that the new approach adopted by the CBT in December - altering the level of short-term (policy) interest rates and at the same time the active usage of liquidity management as well as reserve requirement ratios (RRR) - will be the new policy. The new approach to monetary policy aims to achieve an external and domestic balance, i.e., current account, financial stability and inflation. The MPC declared that low(er) interest rates and high(er) RRR will be here to stay for a considerable time and the approach will address simultaneously financial stability and price stability.
The main focus will be to control credit growth: The CBT's new policy mix will address the ongoing rapid growth in loans, especially that of consumers, which has been expanding at a rate of around 40%Y and heading towards 50+%. Until inflation bottoms out and starts rising to a degree that causes a deterioration in inflation expectations and widens the credibility gap for the CBT to act, we think it very probable that the policy rate will be kept low while successive RRR hikes are likely. In the past we used to concentrate almost solely on inflation and the reasons behind it, but paid little attention to credit growth as interest rates were relatively high and the penetration rate was low. However, we will now be monitoring changes in the growth rate as well as the overall tendency in consumer loans to judge or predict if the CBT will make further moves.
Based on the CBT's strong emphasis on the desire to lower credit growth to around 20-25%Y, we believe that both the realised and implied growth rates will become an important part of policy consideration. Immediately following the CBT's rate cut in December and the hike in RRR, we believed that the overall impact of the change would be expansionary. However, the recent move in RRR despite the 25bp cut in policy rate seems to us to be a corrective move.
Changes in forecasts: On the inflation front, the CBT made a couple of key assumption changes that resulted in an upward revision of the CPI inflation forecast from 5.4%Y to 5.9%Y (40bp higher than the inflation target) in 2011. The first change was to raise the assumption on food price hikes in 2011 from 7%Y to 7.5%; this added 15bp to the original forecast. The second change added 35bp, stemming from a price assumption revision for oil from US$90/bbl to US$95/bbl. The inflation forecast for 2012 remains at 5.1% and 5% thereafter. Our forecasts are slightly more conservative, at 6%Y for 2011 and 5.5%Y for 2012. However, we are reviewing our forecasts, for 2011 especially, to determine how much of an upgrade is necessary, taking into account the weaker currency outlook (and higher global oil prices).
Current account is the other weak spot: Not only the CBT but also various functions within government have been addressing the problematic expansion in the current account for some time. It is true that the bulk of the deterioration has been on the back of rising energy import costs, but the deterioration in the non-energy component of the deficit is noteworthy. As we have highlighted in the past, the non-energy component provides a better gauge of the seriousness of the situation, and is a better reflection of signs of overheating in the economy and/or currency misalignment. In that respect, the ongoing trend is not highly encouraging and the efforts to at least curb imports via a weaker currency present some upside (i.e., moderation).
Can we predict the policy rate and RRR changes? Ahead of the surprise rate cut of January 20 and the expected RRR hike of January 24, our expectation was that the policy rate would be kept unchanged for most of the year before a 150bp hike in 4Q11. Based on the new approach to policy-making and the seemingly determined central bank, we now expect another 25bp cut in the coming months, most likely to be delivered in February (so that the policy rate eases to 6%), accompanied by another hike in RRR. The CBT could conceivably decide to hold the policy rate unchanged in February or afterwards, as the currency is likely to continue to depreciate gradually. On the other hand, credit growth is still so strong that it may require further RRR hikes. Later in the year, we expect some policy rate tightening and pencil in 100bp so that the policy rate reaches 7%. But given the high level of uncertainty, we acknowledge the fact that predicting the course of the combined policy response will be extremely difficult.
New RRR rates and further extraction of liquidity may bear fruit: We have to admit that the recent hike in RRR encouraged us in the sense that the notable extraction of liquidity from the system (TRY 9.8 billion), which will become effective as of February 18, could actually be considered as tightening despite the cut in policy rate. The new RRR rate of 10% on deposits of up to 1 month in maturity, 9% for those of 1-3 months, 7% for 3-6 months and 6% for up to 12 months are likely to start showing as a gradual rise in loan rates. In fact, some private banks have already raised their loan rates by around 5bp, especially on consumer loans. This is likely to help credit growth moderate if further upward adjustments follow. That said, we are not fully convinced that this will cause a sharp decline in the near future.
A tougher period to guess the next move: As with the Inflation Report, the CBT omitted to provide information or guidance on the course of the policy rate (or changes in the RRR). This leaves significant room for error on the part of central bank watchers. To add to the challenges already at hand, the CBT mentioned that future policy responses via changes in the policy rate and/or RRR may take place at the same time or separately, in the same direction or in different directions. Predicting monetary policy in Turkey will be highly challenging this year, and this calls for caution, in our view.
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