Fra BNP Paribas
Two weeks after the presidential election and its radical impact on the political landscape, the likely overall tone of US economic policy under President Donald Trump remains uncertain.
Notwithstanding this uncertainty and his continued protectionist rhetoric – he reiterated this week that he would withdraw from Trans-Pacific Partnership on his first day in the office – the financial markets continue to upgrade the outlook for the US economy. Given the prospect of significant fiscal expansion, the US equity market has reached record highs and the dollar index (DXY) has risen above the recent peak in 2015.
A stronger dollar might eventually start to hurt growth in the US or cause serious problems in other parts of the world. For the time being, though, there does indeed look to be a good chance that the US economy will accelerate. We assume that about one-third of Mr Trump’s plan will make it through Congress, with a bit less during his first year (2017) and a bit more in the second (2018); some infrastructure spending could come even later.
As a result, we expect the deficit to widen by about 1.6pp in the first two years of his presidency, boosting growth and inflation. We see GDP growth of close to 2.2% y/y in 2017 and 2.8% y/y in 2018, with core PCE inflation rising to about 2.3% y/y at the end of 2018 from the current 1.7%.
This prospect will inevitably have implications not just for the US Federal Reserve but also for monetary policy across the globe, to varying degrees. As for the Fed, we naturally see it responding with higher rates. After an expected December hike, we see two 25bp hikes in 2017 and four in 2018, with more likely in 2019. That said, the size and timing of fiscal expansion is uncertain at this point.
Moreover, the Fed is limited in its ability to respond to potential fiscal policy shifts before they become legislated. For now, we continue to expect more Fed talk about how policy could affect its outlook before any changes to its Summary of Economic Projections. For the European Central Bank (ECB), stronger US growth and a rising USD may lead some on the Governing Council to push for a limited reduction in the pace of asset purchases.
Certainly, recent comments suggest an internal discussion underway. As growth has proved resilient and broadly in line with the ECB expectations, and headline inflation is now beginning to rise, as are inflation expectations, a case can be made for such a change to policy. In March 2016, the ECB increased the pace of purchases to EUR 80bn a month from EUR 60bn in response to perceived downside risks to growth and fears that persistent near-zero inflation was unanchoring expectations.
Conditions having improved since then, so one could argue that it is reasonable to return to the original pace of asset purchases. That said, one can equally argue that growth, while resilient, is not especially strong. Moreover, core inflation remains below 1% with no obvious sign of an upward trend, something that has been noted by ECB speakers of late.
Ultimately, the decision on whether to reduce the pace of asset purchases may, therefore, be less a function of the economy outlook and more one of practicality; at some point, the ECB is going to run short of assets. In essence, the ECB faces a trade-off between the ultimate length of the programme and the pace of purchases. It may, therefore, be deemed more sensible to lower the run rate, allowing the programme to run for longer and to be ended in a gradual way. Our impression is that while there may not be a clear consensus on when to start ‘tapering’, there is a common objective among Governing Council members to avoid an abrupt end to the programme.
Tapering early allows more flexibility in future. On balance, we expect the ECB to announce a reduction in purchases at its December meeting, to EUR 60bn per month from March with the programme extended by six months to September 2017. We would expect any announcement of a reduced purchase pace to be accompanied by dovish rhetoric and to be presented as a marginal change, rather as a signal of an imminent end to quantitative easing.
The majority on the Governing Council still seem to be of the view that the economy remains dependent on monetary stimulus and that when it is withdrawn, it will need to be done relatively slowly. For the Bank of Japan (BoJ), the strengthening of the dollar is an unexpected tailwind. The BoJ has run out of viable policy option to achieve 2% inflation and, in September, shifted to a waiting game with its ‘yield curve control’ policy. Its current strategy is to await a positive demand/ … and the Fed to keep on hiking in 2017 and 2018 There are arguments for ECB ‘tapering’ … We expect ‘tapering’ to be announced in December
Market remains upbeat about the US
We expect US growth to accelerate … … and against, but … … no one wants an abrupt end to QE Stronger dollar is a tailwind for the BoJ Hiroshi Shiraishi inflation shock and, when it comes, to amplify its effect on inflation by resisting to the resulting upward pressure on long-term rates and thereby lowering real rates.
Indeed, the BoJ last week showed its strong intention to control the yield curve by announcing an unlimited fixed-rate buying operation for Japanese government bonds in the three-year and five-year sectors, though there was no bid for it. This policy stance is providing an impetus to yen depreciation. However, the incoming US administration would not be too happy to see the yen depreciating massively, particularly with Japan’s current-account surplus likely to widen to over 4% of GDP in 2017.
Significant yen depreciation from here is also likely to be unpopular among Japanese households, as it hurts their purchasing power. In fact, back in late 2014, when USDJPY rose above 120, a strong backlash started to emerge from the Japanese public, and even the BoJ’s Governor Haruhiko Kuroda was obliged to talk up the yen in mid-2015 when it threatened to keep climbing beyond 125. At any rate, if the yen continues to depreciate, the market would start testing the BoJ’s commitment to keep the 10-year rate at around zero. In China, USD strength and higher US rates add to a difficult ‘trilemma’.
As the current pricing mechanism for fixing the rate is linked to the China Foreign Exchange Trading System RMB index, the stronger dollar has prompted rapid depreciation in the RMB against the USD in the past week. And capital outflow pressure is likely to have heightened amid quick narrowing in the onshore–offshore interest-rate spread. For monetary authorities, relatively independent domestic monetary policy is certainly a priority. While policymakers do not want the currency to devalue too fast, the option is to tighten controls over capital outflows and to run down FX reserves.
