Central banks at the core of financial markets

Economic outlook - 9/28/2016

Central banks reiterated their concerns about GDP growth, but stock markets took heart from their dovish tone. The Bank of Japan will put in place a new monetary framework “QQE with Yield Curve Control”, to achieve the price stability target of 2%. The European Central Bank could eventually take the same approach as well.

The central banks have again expressed their concern over GDP growth. The Fed kept its benchmark rate at 0.50%, while the Bank of Japan took a step forward by proposing a new monetary framework. The  stock markets welcomed the dovish tone of these announcements: the S&P 500 index ended the week up 1.2%, while emerging markets – which are highly sensitive to liquidity conditions – climbed 3.6%. As a result, the yield curve flattened and the US dollar lost ground. On Friday evening, the dollar slipped 0.6% against the euro to $1.123/euro.

As we expected, the Federal Reserve kept the Fed funds rate at 0.50%, while hinting even more at a rate hike in December. The Fed’s post-meeting statement noted that arguments in favour of monetary tightening had gained ground, thus striking a tone similar to that of Mrs. Yellen’s comments at the Jackson Hole press conference on 26 August. Most members of the Federal Open Market Committee (FOMC) still expect a rate hike before the end of the year, as seen in their new projections (see left-hand chart).

That said, the FOMC members again reduced the number of rate hikes they expect and their
projection of the long-term Fed funds rate. They only expect two increases in 2017 (versus three before) and believe that the long-term Fed funds rate will reach 2.875% (versus 3.00% before). They are even more pessimistic about long-term US GDP growth, which they now estimate at 1.8% instead of 2.0%.

  • We still expect the Fed funds rate to be raised in December 2016. In its statement, the Fed confirmed its intention to raise its benchmark rate before the end of the year, although its decision will remain datadependent.
  • In our view, and as forecast by the FOMC members, the Fed funds rate is likely to be raised two more times in 2017, bringing it to 1.25%.
  • This rate-hike cycle should be more gradual than expected, however, and this will limit upward pressure on the dollar.

The Bank of Japan (BoJ) kept its deposit rate at -0.1% and noted that it would continue buying “about” 80 trillion yen per year in assets. But it also announced that it would set a yield-curve control to keep 10-year government bond (JGB) yields at around 0%. Its aim is thus to “artificially” steepen the Japanese sovereign yield curve in order to support profits in the financial sector. This means that the BoJ intends to keep its quantitative easing policy and negative deposit rate in place for the foreseeable future while preventing the 10-year yield from entering negative territory out of concern for the financial sector.

  • The BoJ has thus demonstrated that central banks can always go further and that they have the tools they need to influence bond yields regardless of maturity (see charts above).
  • The BoJ has introduced a new monetary policy framework “QQE with Yield Curve Control” that could also be used by the European Central Bank.
  • Negative interest rates are set to last. In noting its desire for inflation to surpass and remain above 2.0%, the BoJ confirmed its intention to continue its current monetary policy longer than planned. Its yield-curve target should allow it to keep a negative deposit rate without causing excessive damage to financial institutions.
  • Although investors welcomed these announcements, which lifted financial shares, distrust of the BoJ could return. We still have our doubts that this policy will push up inflation expectations.
    Renewed concerns about the effectiveness of its strategy would push up the yen against the dollar and weigh on the Nikkei index.


The ECB will closely observe the financial consequences of this new monetary approach (see our 22 September comment), especially in view of the Eurozone’s ongoing struggles. The September flash PMI composite index dropped slightly, from 52.9 in August to 52.6 in September, its lowest level since the start of 2015 (see right-hand chart). We still expect economic activity to edge upward before the end of the year on the back of increased mortgage lending and growing public spending. But this may not be enough for the ECB to reach its inflation target.

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