Global economic strength allows Reserve Banks to shrink balance sheets

October 2017

Global Outlook Stronger as Reserve Banks become Shrinking Violets

By Danica Hampton

The outlook for the global economy continues to look robust. If anything, we see upside risks to our forecasts of global GDP at 3.1 per cent this year and 3.3 per cent in 2018. However, there are still some downside risks on the horizon coming from tighter financial conditions and geopolitical tensions.

Against a backdrop of robust global growth, central banks are increasingly confident about returning monetary policy to more normal settings.

We expect the United States Federal Reserve to hike by 25 basis points (bps) in December and deliver 75bps of hikes in 2018. The Bank of Canada will likely hike again in October and raise rates 50bps in 2018. There is a good chance the Bank of England will hike rates before the end of the year (despite the Brexit negotiations). And next year, we expect Sweden’s Riksbank, Reserve Bank of Australia and Reserve Bank of New Zealand to also begin raising rates. Overall, the average policy rate in advanced economies is expected to rise from its current level of 0.45 per cent to 0.93 per cent by the end of 2018.

Global balance sheet tapering is also coming. The Fed announced its balance sheet reduction will begin this month. The Bank of England has stopped, and the Bank of Japan has slowed, asset purchases. Meantime, the European Central Bank is expected to end its asset purchasing program in 2018. Overall, advanced economy net asset purchases are likely to fall from $100 billion a month to roughly zero by the end of 2018.

While monetary policy is expected to tighten over the coming year, fiscal policy worldwide is likely to add stimulus. We estimate the recently announced US tax package could cut taxes by US$2 trillion over the next 10-years and boost US GDP by three per cent over the next five years. In Germany, recently re-elected Chancellor Merkel’s coalition is also expected to support growth through tax cuts and public investment (in energy, transport, digital and defence).

All-in-all, looking ahead, there appears to be a bias towards higher interest rates worldwide. The Fed appears comfortable to look through the recent soft patch of US inflation and is content to raise rates. Meantime, the hurdles to further easing in Europe and Japan also look much higher. Overall, this means inflation will likely remain well-contained over the medium-term. The outlook for growth is more difficult to predict, as it will depend on the balance between monetary tightening and fiscal easing.

With asset valuations stretched on a variety of metrics, many investors were nervous that tighter monetary conditions could lead to a major correction in asset prices (especially in equity and credit markets). However, the recent fiscal stimulus announcements have calmed these fears. The anticipated fiscal easing should help asset markets continue to perform, despite a backdrop of tighter financial conditions and higher interest rates.

Danica is an Investment Specialist at Citi Australia

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