A new season for economic policy?
26 May 2017 | Joe Davis
In addition to preparing my garden for the summer, my spring rituals include reflecting on things that have occurred over the past year.
As always, some things have changed, while others remain the same. My children are a year older, but for some reason they still need help with their homework when I'm mulching.
More broadly, we've seen another year of progress in the stabilisation of the global economy and another flurry of policy discussions in the news media. This time, though, central bankers have to share the stabilisation spotlight with elected policymakers.
The optimist in me believes that the policy changes being discussed in Washington, London and other capitals reflect and can help drive a sustained expansion, but the realist in me understands how difficult that could be.
Economists view monetary policy as a reflection of economic conditions. Just as I cut my grass only when it needs it, central bankers adjust monetary policy only when economic conditions warrant it. While the Bank of England stays its hand and the course of Brexit negotiations remains uncertain, the United States Federal Reserve – against the backdrop of a strengthening US economy – is gradually normalising policy. That includes raising its policy rate and, likely sometime later this year, starting to reduce the size of its balance sheet.
Just as the purchase of assets by the Fed, Bank of England, and other central banks to expand their balance sheets was a real-world experiment in monetary policy, the implications of a gradual roll-off of assets held by central banks are largely unknown. This is why, much like the process of increasing interest rates, balance-sheet normalisation in the US and elsewhere will be slow and gradual.
We at Vanguard believe that, in order to minimise global market impact, the Fed's action plan will include three important components:
- Public communications about the plan will continue, with an announcement about the agreed-upon program coming in the late summer or early fall.
- The framework will consist of two key points: the pace of roll-off and the targeted size of the balance sheet at the end of the program.
- The Fed will initially use only one "tool" at a time and pause changes in the policy rate until the impact of balance sheet roll-off is better understood. Looking to the end of 2018, it is difficult to envision a scenario where the policy rate is 2% or greater.
If the announcement and implementation of the roll-off plan are handled in a clear, transparent and gradual manner, there should be minimal market effect.
Change is a process, not an event
In the UK, fiscal policy is unlikely to shift radically except in the event of a decisive Labour victory on 8 June. In the United States, on the other hand, changes are afoot on the fiscal-policy front – changes that many, including myself, hope will push the US back toward pre-recession rates of growth. All that said, we believe that expecting big changes in 2017 on either side of the Atlantic may be overly optimistic.
From the US perspective, fiscal stimulus and structural changes, including infrastructure spending and tax reform, have the potential to shape the economic and financial market environment for years to come. These policies need to be vetted and implemented with care. Even if we were to see one or the other announced later this year, the economy would not realise their benefits until sometime in 2018. The most we can hope for this year would be for benefits from increasing levels of confidence about the potential for policy change. While these could very well push growth and inflation higher in the near term, recent softness in US economic data and political gridlock in Washington may begin chipping away at this positive sentiment.
The last 12 months have seen significant change in economic conditions in many countries, but particularly in the United States. Growth is stabilising and inflation continues moving toward the Fed's target of 2%. As with any economic data, rates of growth and inflation will ebb and flow, but we as investors should look past those toward bigger-picture trends.
Even if there are short-term boosts to US growth or inflation this year or next, the realist in me remains concerned that the types of policies being proposed today, while a step in the right direction, won't be enough to counteract the structural headwinds we outlined in our 2017 Economic and Market Outlook: demographics, technology and globalisation. Aside from the possibility of near-term cyclical boosts to GDP growth and inflation, longer-term we would expect each to hover around 2%, compared with pre-crisis average rates north of 3%. But rather than being seen as weak, such conditions should be viewed as fundamentally sound given the pressures of structural forces.
Seasons change, and so do policies, though hopefully not as frequently. Investors would be well served in the long term to focus more on spring cleaning and autumn leaf-raking than in trying to construct portfolios that fit an ever-evolving policy environment.
While policy certainly can shape our economic and financial market environment, trying to predict with precision the timing, impacts and duration of specific policies is as fruitful as my looking for help moving the mulch out of my driveway.
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Issued by Vanguard Asset Management, Ltd, which is authorised and regulated in the UK by the Financial Conduct Authority.