THE United Kingdom caused a brief moment of concern in the global financial markets in September, when Scotland held a referendum on independence. For a few days, investors contemplated the possibility of the disintegration of one of the world’s more enduring multinational states. The decision went against independence, and the risks associated with separation faded from the markets.
However, what happened in the UK is not the only thing that investors need to worry about. They need to consider the possibility that the world’s major central banks will pursue opposing policies.
In the United States, barring an unforeseen calamity, the quantitative policy of printing money on purpose will come to an end at the US Federal Reserve’s (the Fed) meeting in October. With that, investors will ask the inevitable question: “What next?” What is next is monetary policy tightening, raising the Fed funds’ interest rate from its current zero percent. When and how quickly the Fed chooses to start raising interest rates will be a source of considerable speculation. Already, two Fed members dissented from the stable-policy majority view (albeit over different facets of that policy).
The Bank of England (BOE) is also experiencing dissent within its ranks. This signals a desire to raise UK interest
rates, perhaps, as early as November. This is less to do with the threat of inflation (which remains well-contained in the UK) and more about maintaining a balance in the economy. After almost six years of unchanged interest rates, it would appear that British consumers have forgotten that interest rates can go up, as well as down. With consumer spending accelerating, the BOE has an incentive to remind the public that there are costs associated with credit.
The Anglo-Saxon economies are, therefore, moving to tighten interest rates, and in the case of the UK, that could come as early as this year. Elsewhere, the euro area is going in completely the opposite direction. European Central Bank (ECB) President Draghi has crossed the monetary-policy Rubicon and taken one of the ECB interest rates to negative territory. While not prepared to make an open-ended commitment to buy
government bonds, the ECB’s governing council has committed to expand its balance sheet—the “diet” version of quantitative policy. More measures may yet be necessary, as growth remains weak.
Meanwhile, in Japan, the illusion of Abenomics seems to be losing some of its luster. The approval rating of Prime Minister Shinzo Abe’s Cabinet has dropped to below 50 percent, which signals depressed domestic consumers and, at the same time, makes the political process of achieving reform more difficult. If structural change and fiscal stimulus become harder to achieve, the pressure on the Bank of Japan (BOJ) to do even more with regard to its quantitative policy is only likely to increase.
How has this divergence of policy come about? The simple answer is “banks”. In the Anglo-Saxon economies the 2008 financial crisis led to the swift reform of the banking sector, with banks being required to recapitalize early. While painful at the time, US and UK banks are now strong enough that they are cautiously prepared to lend money. The quantitative-policy accommodation of the last several years is finally being put to work in the economy and is stimulating growth. The US economy has exceeded 3-percent annualized growth for three of the last four quarters, and the UK economy is expected to be the fastest-growing economy in the Group of Seven this year.
Meanwhile, in the euro area, banks are still reluctant to lend—or, at least, reluctant to lend at a price that borrowers wish to borrow. The ECB’s flood of liquidity is held back by banks that fear the consequences of further regulation and higher capital requirements (under the new regulatory regime of the ECB). Meanwhile, Japanese banks are willing to lend, but they are biased toward lending outside of Japan, not inside. As a result, domestic demand in the Japanese economy remains weak.
The differences in the Anglo-Saxon banking sectors, on one hand, and that of the euro area and Japan, on the other, mean that policy and economic-growth divergence is likely to stay in place for some time. Until now, the focus of investors has been on the euro area and, with that, a bias toward policy accommodation. In October and November that mentality is likely to shift. With the Fed and the BOE clearly signaling higher policy interest rates, the mentality of the markets is likely to be biased toward policy tightening. If investors think in terms of tightening, rather of more easing, then the implications for financial markets could be felt quite widely.
Paul Donovan is the managing director and deputy head of global economics of Zurich-headquartered UBS. He is responsible for formulating and presenting the UBS Investment Research global economic view, drawing on the bank’s worldwide resources.
Donovan took up philosophy, politics and economics at Oxford University. He holds an MSc in financial economics from the University of London.
In the Philippines his column appears exclusively in the BusinessMirror once a month.