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A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.

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Sep 07 2017

Central Bank “Normalization” Plans on Shaky Ground

Since their “Mission Accomplished” moment a couple months ago, faith in the major central banks’ ability to “normalize” policy has receded dramatically. In June, they were singing the same, more hawkish or less dovish, chorus, including a declaration from European Central Bank (ECB) President Mario Draghi that “the threat of deflation is gone.”



As our chart shows, in the days following those intimations, market-based probabilities of one or more rate hikes by December 2018 also mounted, surpassing 90% in the U.S., almost mirrored in the Eurozone, and surging past 80% in the U.K. Even in Japan, the analogous rate hike probability tripled in less than two weeks to approach 40%.

It has been mostly downhill since, with the probabilities sliding to 71% in the U.S., 55% in the U.K., 46% in the Eurozone, and 2½% in Japan. In other words, financial markets assess the odds of no more rate hikes by the end of next year to be 97% in Japan, 45% in the U.K., 54% in the Eurozone, and 29% in the U.S.

Those shifts represent quite a comedown from the “Mission Accomplished” moment. They reveal just how doubtful the markets have become that monetary policy can be “normalized” in the foreseeable future.

What the central banks’ inability to “normalize” monetary policy nearly a decade removed from the Global Financial Crisis reflects, in large measure, are deep-rooted structural problems, in spite of wishful thinking on their part “that we have turned the corner in a structural sense” (ICO Essentials, June 2017). An additional issue is the separate, cyclical downturn in inflation, whose impact on market rate-hike expectations – despite the Fed’s focus on “one-off factors” suppressing inflation – is increasingly obvious.

More than a year ago, we had predicted that, “[n]otwithstanding the long-term lowflation story … inflation is likely to rise further … In effect, this is a Baked-Alaska economy, with a chilly core of structural lowflation and a sizzling topping of cyclical inflation” (USCO Essentials, July 2016). That chilly core of structural lowflation remains intact, but the cyclical inflation topping is fast losing its sizzle – along with the belief that central banks can “normalize” policy any time soon. Without a fresh cyclical upturn in inflation, the central banks lack cyclical support for “normalization.”

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