A tale of two central banks, both hindered by politics

<p>The Federal Reserve left policy unchanged when it announced its decision on Wednesday. While it said that the case for tightening rates had strengthened, it […]</p>

The Federal Reserve left policy unchanged when it announced its decision on Wednesday. While it said that the case for tightening rates had strengthened, it would wait for further evidence before actually pulling the trigger and hiking rates. The Fed only needs “some” further evidence before it hikes rates, which suggests that the bar to raising rates next month has been lowered.

A Donald-shaped elephant in the room at the FOMC

However, the elephant in the room at the Federal Reserve was the US election next Tuesday. Even though two members of the FOMC did vote to raise rates, it would be a brave central bank that would hike interest rates during such a contentious election cycle. If Trump wins the election next week, then the market turmoil that could be expected from his win is likely to delay the FOMC’s decision to raise rates in December, regardless of what this Friday’s NFP report tells us about the state of the US jobs market.

Politics gets in the way of central banking

Central banks are increasingly being hindered from doing their job properly by unprecedented levels of uncertainty, mostly political in nature. This can be seen in both the US and the UK. It’s super Thursday for the Bank of England today, when it will announce interest rates and its latest Inflation Report. The backdrop to this meeting is a tricky one for the BOE. Not only has the Governor come under attack from the pro-Brexit bunch at Westminster, but also UK growth has surpassed its expectations, and its gloomy forecasts about the UK economy post the referendum have not come to bear.

BOE may raise GDP outlook, but outlook is still negative

Although we expect the BOE to raise its growth forecast for this year and next, any potential uptick in UK asset prices that are linked to growth, like stocks and the pound, could be limited as the Bank reiterates the long-term impact of Brexit on the economy, including risks to trade and business investment that could permanently dent GDP going forward. Read our full BOE Inflation Report preview here: https://www.cityindex.co.uk/market-analysis/forex-news/40111992016/inflation-report-preview-carney-and-co-to-remain-on-hold-for-now/

Essentially we have two central banks that could be hiking rates and trying to return monetary policy to some sort of normality if it wasn’t for the political circumstances of their countries. If the UK hadn’t voted for Brexit, the BOE may have been considering raising rates at this meeting (a perfect time to do so, when it could explain its decision during the Inflation Report press conference). Ironically, higher rates are exactly what the Brexiteers in Westminster have been calling for.

Why the FOMC is so keen to hike rates in December

Likewise in the US, the Bank has pointedly directed the market to think it will raise rates in December rather than November. There was only a 14% chance of a rate hike from the Fed yesterday, whereas the market is currently pricing in a 70% chance of a hike next month. This is all down to the timing of the election. The Fed would not want to hike rates, only to reverse the decision if the markets throw a hissy fit at the election result next week.

Why central banks won’t save the voting public from the ramifications of their decisions

Interestingly, we sense a subtle shift in global central banking stances. The Fed has already suggested that the government will need to step in to do the heavy lifting of boosting growth so that it can normalise monetary policy rates. Likewise, we expect the BOE to mention later today that fiscal policy, set by the government, will also be necessary to steer the UK economy through the choppy waters of Brexit. Due to this, central banks may not step in to supress market volatility as a result of democratically decided political decisions, like Brexit or the US presidential race. Thus, if the markets go into free fall on the back of a shock win for Donald Trump next week, or if UK asset prices rapidly decline after Article 50 is triggered early next year, then we could see central banks look the other way, while market volatility plays out organically.

In the short term, the pound could struggle if Carney and co. do not upgrade their GDP forecasts. Interestingly, 10-year Gilt yields have fallen more than 10 basis points in recent days. We think this is part of a global retreat in bond yields led by Treasury yields, but a dovish BOE could push them down further. The pound, inversely, has been strengthening, largely on the back of a weaker dollar caused by US election fears.

This could be an interesting new era for central banking, one where they are not at the mercy of market volatility, and where they will not try to protect asset prices. This could make it one hell of a ride for financial markets in the coming days and weeks.

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