Central bank watch

Central banks in the advanced world enter 2014 with a better outlook, with growth improving and financial risks receding. That said, inflation is still uncomfortably low and the recovery uneven.  Policy is likely to be more varied across difficult regions, although in general central banks will err on the dovish side given the experience of the last 5 years.

The table above summarises the current stance of policy and guidance by the major central banks. Interestingly the mix of quantitative measures and guidance varies quite a lot, with the use of unconventional policies clearly still a work in progress.  The Fed and the Bank of England have quite similar guidance structures in terms of thresholds, although Fed continues to expand its balance sheet. Guidance from the ECB and BoJ is less well defined, although the BoJ is extremely aggressive in terms of balance sheet expansion and the ECB constrained on this front.

For the Fed, communicating the thresholds in guidance has been challenging thanks to a sharply dropping unemployment rate.  A large drop in participation rates has seen the unemployment consistently beat expectations, although this is not a great signal that labour market conditions are tightening particularly quickly. 

This probably won't change the current path of policy, with other key indicators performing more in line with expectations.  It is also unlikely to sway the FOMC from their current guidance on the Fed Funds rate, which should keep the yield curve reasonably well anchored.

The ECB is in a much more difficult situation, with the unemployment rate still very high and inflation dangerously low. The signs of better growth are welcome, but in an ideal world the central bank would be doing more support to growth.

It's clear over the last few years that the ECB's reaction function has changed from the Trichet years, with the most recent cut in rates in response to poor inflation numbers a recent sign of this.  If growth remains weak, inflation poor and monetary dynamics slow, the ECB may look to more novel ways of boosting growth given QE seen elsewhere is currently not possible under the Euro.

Japan have been dabbling with unconventional policy measures for a long time and 2013 heralded a much more aggressive monetary approach. In the early stages it appears to be having some success, with inflation and inflation expectations rising.

Given how long Japan has been stuck in a deflationary environment, it seems likely that the BoJ will remain very aggressive even if inflation approaches 2%.  Indeed, while the hurdles are not explicit thresholds like elsehwere, it seems like the bar is set pretty high for the BoJ to change tack.

The Bank of England finds itself in an usually positive position, with growth rates quite good and inflation higher than elsewhere.  As the chart left shows, the magnitude of the upside surprise in the UK has been much larger than anywhere else, although that is partly a function of the bar being set very low.

Nonetheless, labour market dynamics look more favourable in the UK than the US and thresholds for a rise in the Bank Rate look closer than anywhere else.  There is a risk that these thresholds are breached in 2H14, although the bank is unlikely to do anything in the next 6 months.