Last week’s policy decisions by large central banks indicate that monetary policy in advanced economies will diverge significantly in the coming quarters.
The US Federal Reserve raised interest rate by 25 basis points on Wednesday. On Thursday, the European Central Bank (ECB) announced that it would end its asset purchase programme at the end of the year. On Friday, the Bank of Japan (BoJ) decided to keep its policy stance unchanged. The difference in the policy stance of large central banks will increase complications for global financial markets and put more pressure on emerging market currencies.
The economic projections put out by the Fed board shows that it will raise rates at least twice more this year and three times next year. It also shows that the US central bank expects growth and inflation to move up, and the unemployment rate to fall further. Although most economic indicators are now moving as expected, slower wage growth is puzzling policymakers. It is likely that wages could start rising significantly with further tightening of the labour market. This could push inflation, which is moving closer to the target. While it is possible that the Fed will allow inflation to overshoot the target of 2% for a while, a significant buildup in prices would force the US central bank to tighten policy at a faster pace. This would not only affect capital flows, increase volatility in the global financial market, but will also affect growth prospects for the US itself.
To be sure, things will not be easy for financial markets even if the Fed moves as widely expected. As Reserve Bank of India (RBI) governor Urjit Patel noted in an article in the Financial Times recently, emerging market economies are facing a double dollar whammy. Normalization of the Fed balance sheet and higher bond issuance by the US government to fund tax cuts is affecting dollar liquidity.
Aside from developments in the US, as noted earlier, the widening difference in the monetary policy stance of large central banks will create complications for both financial markets and policymakers. The ECB has announced that it will reduce the quantum of asset purchase from September and end it in December. However, it does not expect to raise rates until the summer of 2019. Meanwhile, the BoJ has left its policy stance unchanged and will continue to manage bond yields, as inflation continues to undershoot the target.
Financial markets and policymakers will need to prepare to deal with this divergence. Assuming that the market will price in the next two Fed hikes, the 10-year US government bond yield will move closer to the 3.5% mark by the end of the year. Consequently, the difference between the US and the German 10-year bond yield will be about 3%. The difference will be even higher in the case of Japan. This will open up lucrative opportunities for carry trade. Some of the large institutional investors would be tempted to borrow in Germany or Japan, for instance, and invest in high yielding US assets. While this could possibly suppress yields to some extent, it will add to existing risks in the global financial system.
Also, higher demand for the US dollar to undertake carry trades will further drain dollar liquidity from the financial system and push up its value. Drying liquidity and an appreciation in the US dollar will intensify the pressure on emerging market currencies. Additionally, a part of the portfolio capital that came into emerging markets in search of yields in recent years would also return with the increasing risk-free rate in the US. A number of emerging market countries raised policy rates in recent weeks. The trend is likely to continue in the near term.
Ten years after the financial crisis, the global economy is slowly moving to normalcy. However, the divergence in the path of policy normalization in advanced economies and higher cross-currency volatility could make this transition difficult for a number of countries, especially in emerging markets. Although emerging market economies are better prepared compared to the taper tantrum, volatility in financial markets could still put some countries with weaker macros in stress.
In the near term, Indian financial markets will also be influenced by global developments, both in terms of monetary policy—which will affect capital flows—and crude prices. RBI did well by pre-emptively raising rates earlier this month.
Although the weakening of the rupee in the near-to-medium term due to a stronger dollar will help exports, its inflationary impact could warrant further policy tightening by the Indian central bank.
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