Monetary Policy – The Great Divide

Monetary Policy – The Great Divide

As viewers of our morning markets and podcasts series will know, we spend a lot of time considering central banks and how they communicate their policies along with providing analysis of likely outcomes. Right now, a desire to achieve price stability (controlling inflation) and promote maximum employment are what sit front and centre for these masters as they look ahead at the unfolding economic landscape.

Although central bankers have already resorted to some unconventional measures to achieve their aims, such as quantitative easing, the main conventional tool remains the interest rate mechanism. Put simply, loose policy (lowering rates) stimulates growth by reducing the cost of credit in the economy, and tight policy (raising rates) dampens growth as credit becomes more expensive.

Across the globe central bankers have however also had to take note of actions by governments in response to Covid-19. Government policies have caused differences to appear in both price stability and employment, making life more challenging for bankers tasked with monetary management. Below, we examine some of the policy initiatives that have emerged in two of the biggest economies, the US and China, and the corrective actions undertaken by their respective central banks.

 

The US

The US economy has been one of the fastest to recover from the effects of Covid-19. Quicker access to vaccines has allowed reopening to happen at a faster clip than many other economies. In addition, large scale government support for those unable to work during lockdowns has helped enormously. Stimulus cheques were sent directly to consumers allowing levels of demand to remain strong during the pandemic. This caused upward price pressures for many goods and as the economy further reopened the price pressures spread to services feeding demand for higher workers’ wages across many sectors starved of workers.

Currently, the US is extremely close to reaching its goal of maximum employment. The graph below shows the US almost back to its pre-pandemic level of unemployment at 3.5%:

Chart: US Unemployment and Core PCE

Source: Bloomberg, data as of Jan 2022

The ongoing strength in labour market data and inflationary pressures in goods and services have placed pressure on the US Federal Reserve bank (the Fed) to change direction on policy. Furthermore, supply chain issues, continuing labour shortages and prior government fiscal stimulus policy pushing up savings for people to now spend, have all combined to keep the economy strong.

The Fed is now signalling a reduction in the pace of their quantitative easing programme which will also reduce the size of its balance sheet. In practical terms this means pressure for interest rates to rise with projections for interest rates already starting to shift – shown in the dot plot below. This indicates policy is moving from extremely loose to a mild form of tightening.

Chart: Fed Forecasted Interest Rate Hikes

Source: Bloomberg, data as of Jan 2022

 

China

The policy mix in China is very different to the rest of the US, and most of the western world. China’s handling of the original outbreak of the virus was better than most. Consequently their economy has not been as severely impacted.

With less need for China’s authorities to enact fiscal and monetary stimulus the economic rebound evident in China after the initial outbreak has been less pronounced. The economy didn’t suffer as much in the first instance and arithmetically speaking the rebound in growth from a higher base was smaller.

Interestingly, China’s Covid-19 lockdown policy, effective throughout for health policy, is having ongoing consequences for economic growth. Whereas Western economies allowed more freedoms because of vaccine efficacy, in China the efficacy of their vaccines is lower and is undermining the benefit that should have been obtained from having most of their citizens vaccinated. Restrictions on movement are still needed region by region with the authorities in China pinpointing infection outbreaks as they pop up. The impact this has on domestic consumption, as we know from prior experience, is not good.

With a very different approach to the pandemic the inflationary picture in China is also very different. Lower fiscal stimulus and more draconian and frequent lockdowns dampening consumption has helped keep a lid on price pressures. This is evident from the data below on Chinese consumer prices (CPI), with prices increasing and falling within a narrow range:

Chart: Chinese CPI

Source: Bloomberg, data as of Jan 2022

From a central bank perspective, the Peoples Bank of China (the PBoC) is now entertaining supportive (loose) monetary policy measures, such as lowering reserve requirements for regional banks (causing them to lend more) and considering reducing interest rates. Unlike the Fed they appear to have more freedom to loosen policy without igniting inflationary pressures.

 

Summary

Central bankers do not operate in a vacuum. They must take account of actions by their respective governments. Policy initiatives by governments in relation to Covid-19 have differed markedly in the world’s two largest economies, China and the US.

The US economy has rebounded faster and stronger, such that price pressures are proving to be more problematic for US citizens than the citizens of China.

Consequently, monetary policy in the US and China is now desynchronised. Just how far each respective central bank will push policy in opposite directions is something we all need to watch, closely. 

 

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Global Markets, Investing