US:
- Central bank Fed will start balance sheet normalization in October and continue with gradual interest rate hiking cycle
Last Wednesday, 20th September, the federal open market committee (FOMC) of the US central bank left the target range for the federal funds rate unchanged at 1 to 1.25 %. The statement says that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Inflation and the measure excluding food and energy prices have declined this year and are running below 2 %. The FOMC added that storm related disruptions (the hurricanes Harvey, Irma and Maria) and rebuilding will affect economic activity in the near term, but past experience suggest that the storms are unlikely to materially alter the course of the economy over the medium term.
As in previous statements, the FOMC expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily. Apart from that, the FOMC expects that inflation will remain somewhat below 2 % in the near term but stabilize around 2 % over the medium term. As already stated in August, near-term risks to the outlook are judged as roughly balanced, but the committee is monitoring inflation developments closely.
Furthermore, the FOMC announced that it will initiate the balance sheet normalization program in October. The Federal Reserve will gradually reduce the securities holdings by decreasing its reinvestment of principal payments it receives from securities held in the System Open Market Account (SOMA). For principal payments from maturing treasury securities the cap will be 6 bn USD per month initially and will increase in steps of 6 bn at 3-months intervals over 12 months until it reaches 30 bn per month. For principal payments from agency debt and mortgage-backed securities, the cap will be 4 bn USD per month initially and will increase in steps of 4 bn at 3-months intervals over 12 months until it reaches 20 bn per month. The caps will remain in place once they reach their respective maximums so that the holdings will continue to decline in a gradual and predictable manner until the FOMC judges that the Fed is holding no more securities than necessary to implement monetary policy efficiently and effectively.
Gradually reducing the balance sheet securities holdings will result in a declining supply of reserve balances. The FOMC anticipates reducing the quantity of reserve balance over time, to a level appreciably below that seen in recent years but larger than before the financial crisis. The level will reflect the banking system’s demand for reserve balances and the FOMC’s decisions about how to implement monetary policy most efficiently and effectively in the future. The FOMC said that it “expects to learn more about the underlying demand for reserves during the process of balance sheet normalization.” According to the normalization process, the balance sheet will have shrunk by 1,500 bn USD to around 3,000 bn in September 2020 (Figure 1). Our calculation would assume that monthly principal payments are at least as high or above the monthly cap.
In its updated quarterly economic projections, the board members and bank presidents forecast (median) real GDP growth of 2.4 % and 2.1 % in 2017 and 2018. Longer-term (steady-state) growth is estimated at 1.8 % (unchanged to June projections). PCE inflation is projected at 1.6 % and 1.9 % and core inflation is expected at 1.5 % and 1.9 % in 2017 and 2018. Both inflation projections have been revised downwardly by 0.1 percentage points for 2018 compared to the June forecast table.
Finally, the median projections of the Fed funds rate remained unchanged at 1.4 % and 2.1 % for 2017 and 2018 and declined from 2.9 % to 2.7 % in 2019. The longer run Fed funds rate projection decreased to 2.8 %, hence, the estimate for the neutral level of the key rate fell below 3 % for the first time (Figure 2).
CEE:
- Monetary easing in times of growth - making sense of the Hungarian Central Bank
- Overnight deposit rate 10 basis points lower at -0.15 %
- Three-month Central Bank deposits capped at 75 bn HUF to boost liquidity to interbank markets
- Inflation pressure from wages, no concern at all?
At its meeting on September 19th, the Monetary Council of the National Bank of Hungary (NBH) decided to further ease its monetary policy. The overnight deposit rate was lowered by 10 basis points to -0.15 % while the central bank base rate was kept at 0.9 %. Additionally, the limit on three-month central bank deposits was lowered from HUF 300 bn to HUF 75 bn by end-December. Money market rates adjusted swiftly. The three-month Budapest Interbank Offered Rate (BUBOR) fell by 7 basis points to 0.05 % (Friday, September 23rd). The overnight BUBOR even turned negative, minus 6 basis points to -0.03 % on September 20th, reaching 0.00 % by the end of the week. In its statement, the Monetary Council defended its rate decision by a repeated delay in the date of meeting its inflation target. According to the central bank’s September projections, the inflation target of 3 % is expected to be reached in Q2 2019, which is one quarter later than in its June projections.
Based on the recent macroeconomic developments of the Hungarian economy it can be questioned to what extent a further easing of monetary policy can be justified. Inflation has reached 2.6 % in August, after 0.4 % in 2016, and core inflation, which is the main indicator for analysing underlying inflation trends, was at 2.8 %, after 1.4 % in 2016. Hence, inflationary dynamics are well underway. Moreover, further inflationary pressure can be expected from a tightening labor market (Figure 3). The unemployment rate is at an all-time low of 4.3 (July) and average gross wages are increasing at two digit percentages (+12.5 % in H1 2017), also due to an increase in the minimum wage by 15 % for unskilled and 25 % for skilled workers in January 2017.
Improvements in the labor market feed into economic growth. The Hungarian economy is expanding at a rate well above 3 % (y/y) with growth at 3.5 % (y/y) in Q1 and 3.8 % in Q2 2017. Economic growth is mainly driven by domestic demand. Household consumption expenditure continues to expand by 4.1 % in H1 contributing more than 2 % to GDP growth. Moreover, investment picked up by 21.5 % (GFCF, y/y) during the first half of the year after its 15.5 % decline in 2016. The credit market, however, looks less supportive even though some trends point in the right direction. Loans to non-financial corporations have recently expanded (+3.9 %, Q2 2017, y/y) while household mortgages (-1.2 %) and consumer credits (-6.7 %) are still in decline (Figure 4). With loans to the corporate sector expanding and inflationary pressure from the labor market emerging, the central bank’s decision to further loosen monetary policy appears to be rather unorthodox.
As being argued in the central bank’s inflation report of September, the main justification for revising the medium-term inflation projection downwards is a more subdued external inflationary environment. The ECB has recently lowered its inflation projection for 2018/19. The decision to further loosen monetary policy can, therefore, be understood as the central bank weighting external downside risks to inflation as being more significant than domestic upside risks from inflationary wage pressure. Compared to the Polish Central Bank, which faces a similar situation without further easing its monetary policy, the Hungarian Central Bank keeps to be the most dovish within the CEE region. However, the looser its monetary policy gets, the faster tightening will need to be if the inflationary upward pressure from wages proves to be stronger than central bank expectations. Time will show whether prices are as sticky as the Hungarian Central Bank thinks. In light of the 2018 parliamentary election, overshooting the medium-term inflation target of 3 % would also raise doubts about the central bank’s independence and question its primary objective of price stability.