Central Banks On Diverging Paths In 2015

(Kitco News) - With the 2008-2009 global financial crisis finally fading into the rear view mirror, focus turns the Big Three global central banks —the U.S. Federal Reserve, Japan's Bank of Japan (BOJ) and the euro-zone's European Central Bank (ECB).

Is growth finally on solid enough footing to see a shift from the ultra-low interest rates and extraordinary monetary policy measures that have defined central bank activities in recent years? Let's take a look.

The world's top three developed countries see a diverging monetary policy path in 2015. The United States is widely expected to lead the pack with monetary policy rate hikes next year, while Japan and the Euro-zone's central banks remain stuck in a very accommodative or easy monetary policy mode.

"There will be an enormous divergence. The Fed will begin normalization in 2015 while the Bank of Japan and the European Central Bank will be pushing harder or accelerating," said Ryan Sweet, director at Moody's Analytics.

The world's advanced economies have seen a string of record or near record-low levels of official interest rates in recent years. The U.S. Federal Reserve has kept the federal funds rate at zero to 0.25% since late 2008. The Bank of Japan's call rate currently stands at zero to 0.10%, while the Euro-zone's refinancing rate is a mere 0.05%.

Those low interest rates have been an attempt to battle back against low or no growth.

Recent years have seen the U.S., Japan and the Euro-zone either in recession or showing below-trend growth numbers. 2015 is not expected to be much better.

For Japan, which is currently in recession, BNP Paribas forecasts overall 2016 gross domestic product (GDP) growth to total 0.4% in 2015, versus a 1.1% pace in the Euro-zone. On a comparative basis, the U.S. looks like a rock star with at 3.3% GDP pace forecast by BNP Paribas. But, that forecasts remains below the longer-term average around a 3.5% growth rate.

Let's take a look at the major central banks: the Fed, the ECB and the BOJ and see what analysts expect in 2015.

The Federal Reserve

The stronger overall economic growth in the U.S. combined with improvement in the labor market and expectations for a pick-up in inflation have traders braced for a Fed rate hike in 2015.

The Fed's most recent meeting on December 17 failed to deliver any significant surprises. Federal Reserve Chairman Janet Yellen alluded in the press conference that rates won't' rise for at least two meetings," said Moody's Sweet.

Analysts are widely pointing the two-day meeting June 18-19 for the timing of the first rate hike. That meeting is followed by a press conference by Chairman Yellen and analysts see that as an important factor in favor of the June meeting. The April 30-May 1 meeting and the July 30-31 meeting do not have press conferences.

Analysts generally expect a 25 basis point rate hike in June, with potential for the fed funds rate to rise to 1.00-1.25% by year end 2015.

But, even now the timing of the first rate hike isn't a sure thing.

"The Fed is aiming for mid 2015, but the economy needs to cooperate. We need more inflation. It has been too low for too long," said Sweet. The latest 40% plunge in crude oil prices has thrown a wrench into the inflation outlook. And, the U.S. Federal Reserve has its hands tied by its so-called "dual mandate" which includes both maximum employment and stable prices.

The Fed's current inflation target stands at 2.0% —and recent consumer price index (CPI) figures are well below that at around a 1.3% annual pace.

"It is easy to craft a scenario where the Fed gets gun shy as they get closer and closer to June," said Sweet. "The key is wages. We need much stronger wage growth to push inflation back to the Fed's target," he added.

Bottom line: The Fed has broadcast its intention to begin policy normalization. But, the level of inflation could be a key factor in the timing of a move.

Euro-zone

The euro-zone is expected to show moderate economic recovery in 2015 following modest growth of around 0.8% in 2014 and two years of recession in 2013 and 2012.

However, looking into 2015: "they are staring down a deflation threat," warned Moody's Sweet.

"Deflation is a serious threat in the Euro zone and the ECB will have to do more to avoid falling into a deflationary trap. Euro-zone CPI is barely above zero percent," he noted.

While in recent years the Fed and the BOJ have hurtled full strength into quantitative easing, or outright bond purchases, in order to stimulate flagging economies, the ECB has been hesitant. Unlike the Fed or BOJ, the European Central Bank represents numerous countries which creates a challenge to achieve consensus.

Bill O'Grady, chief market strategist at Confluence Investment Management, points to a particular strain of economic theory embraced by the Germans as a key factor holding back the European Central Bank. He pointed to a theory called "ordoliberalism" that has largely driven German economic policies in recent decades as a factor. "Because the Germans live under this believe system, they oppose extraordinary unconventional measures," said O'Grady.

"They believe that [quantitative easing] will cause inflation and a distortion of the economy but it won't cause anything to recover. They are opposed to undermining the hard characteristics of the euro," O'Grady explained.

O'Grady warns that this economic belief is so deeply "embedded in the German national view of themselves that [ECB chief Mario] Draghi is running the risk that Germany will step out of the euro zone at some point."

Tomas Holinka, economist at Moody's Analytics weighed in: The ECB is more conservative. While the Fed and BOJ started buying sovereign bond almost immediately after they have announced QE, the ECB is trying to boost the economy by other tools —LTRO, covered bond purchases, ASB purchases —rather than by government bond purchases. It can be explained by different ECB’s mandate, which prohibits the monetization of public debt."

However, analysts widely expect the ECB to finally pull the trigger on sovereign bond purchases in 2015. Analysts at BNP Paribas expect the central bank to announce sovereign quantitative easing after its next policy meeting on January 22.

Tomas Holinka, economist at Moody's Analytics was more conservative: "We see a 50% chance that the ECB will launch its sovereign bond purchases in the first quarter of 2015."

Bottom line: The ECB is expected to remain in easing mode in 2015 with new policy accommodations possibly on the way.

Japan

Shifting over to Japan, the consumption take hike implemented in April had the unintended consequence of sending the economy back into recession. The Bank of Japan now targets its "monetary base" as opposed to interest rates. Although the call rate stands at the ultra-low zero to 0.10%.

At its most recent meeting, the BOJ "maintained monetary policy settings steady at its December meeting. The BoJ will continue to increase the monetary base at an annual pace of ¥80 trillion. This stimulus program is expected to continue in 2015," said Matthew Circosta, economist at Moody's Analytics.

On a comparative basis, while the ECB has been hesitant about QE, BOJ has roared full steam ahead in its efforts to break decades of deflationary conditions in Japan.           "The Bank of Japan’s asset purchases have surged since 2013 and are approaching an outsize 60% of GDP. This is more than double that of its counterparts at the U.S. Federal Reserve, the European Central Bank, and the Bank of England," said Circosta. See Figure 1 below.

Botton line: economists expect the BOJ to maintain its easy and accommodative course throughout 2015. However, some experts say that further easing efforts can't be ruled out.

Big Picture

Out of the big three economies —the U.S., Japan and the Euro-zone, the Fed remains the only central bank poised to raise rates. "The Fed is the only central bank that has a shot at lifting policy rates in the next 15 months," concluded Cary Leahey, senior advisor to Decision Economics.

By Kira Brecht, Kitco.com

Follow her on Twitter @KiraBrecht