Why soft inflation won’t deter central banks from tightening policy

Thought of the day
by Chief Investment Office 15 Dec 2017

The European Central Bank’s last meeting of the year echoed the trends highlighted by the FOMC earlier this week, with optimism on the growth outlook accompanied by a more cautious tone on inflation. The ECB downgraded its core inflation forecast for 2018 to 1.1% from 1.3%, and President Mario Draghi said that muted domestic price pressures had “yet to show convincing signs of a sustained upward trend.”

But despite softness in inflation, we expect the global trend toward withdrawal of monetary accommodation to continue:

  • Gradualism isn’t the same as inaction. The Federal Reserve is tightening rates and shrinking its balance sheet, and the ECB is about to start reducing its bond purchases. Both central banks are responding to stronger economies, and this week revised up their estimates for GDP growth in 2018.
  • Other central banks are also tightening. On 14 December, Bank of Canada Governor Stephen Poloz expressed confidence that the economy “will need less stimulus over time.” Also on 14 December, the Bank of England said “further modest increases” in interest rates are likely. Both have already started to raise rates.
  • The People’s Bank of China offered its own modestly hawkish signal this week, raising reverse repos and medium-term lending facility rates by 5bps, the first such move in nine months.

We believe that the removal of monetary accommodation reflects the fact that central banks recognize that the global economy no longer needs emergency levels of stimulus. We expect the pace of withdrawal will remain gradual enough not to disrupt equity markets. We remain overweight global equities.

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