Central banks have to admit – financial conditions matter more, creating pressure for a more dovish stance now and limiting the scope for future policy tightening.

After the US Federal Reserve paused its tightening cycle in January and cemented its dovish position in March, and Chinese policymakers introduced new easing measures (discussed here), the ECB also shifted to a more dovish stance.

Put differently, the recent central bank pivot is real and now encompasses policymakers from the world’s largest economies. However, the shift to a more dovish stance differs in size and in its ability to deliver more:

  • China’s People’s Bank of China delivered notably larger cuts in the reserve requirement for banks than in 2015/2016. It could still ease policy on several fronts. Fiscal policy remains supportive too.
  • The ECB issued dovish guidance in March and announced fresh targeted longer-term refinancing operations programmes to support the region’s banks. Its scope to deliver much more is probably limited, especially if President Draghi is replaced by a hawk later this year. While there is room to ease fiscal policy, the political hurdles are high.
  • After signalling a pause and saying it was ready to use its balance sheet if needed, the Fed consolidated its dovish position by:
  1. Adjusting its ‘dot plot’ to show no rate rises in 2019 and only one in 2020 (Exhibit 1)
  2. Revising down its growth and inflation projections
  3. Tapering its balance sheet run-off from May (halving redemptions to USD 15 billion per month) and stopping altogether in September.

Importantly, the Fed said it is attaching greater weight to inflation, raising the bar for a more hawkish stance. In terms of its ability to deliver more, it is clear to us that the Fed is the central bank with the most ‘ammunition’ to ease policy if needed.

Exhibit 1: The Fed in March – a dovish shift in the ‘dot plot’…

a more dovish stance now

Source: Bloomberg and BNPP AM, as of 29/03/2019

An unexpected reversal

The reversal in balance sheet policy away from a swift ‘autopilot’ reduction to halting redemptions is a focal point for markets which were hurt in 2018 as quantitative tightening fears dominated. Indeed, as exhibit 2 shows, the start of the run-off destabilised equity markets. Now the run-off is set to end much earlier than expected.

Exhibit 2: …and switching off ‘autopilot’ balance sheet trimming

a more dovish stance now

Source: Bloomberg and BNPP AM, as of 29/03/2019

Why have central banks flipped so quickly?

We believe that (especially) the Fed realised that the combination of a slowing global economy and policy tightening was toxic for financial markets (exhibit 3). It is clear that after almost a decade of quantitative easing boosting markets, central banks are now more sensitive to financial conditions than in prior cycles.

Exhibit 3: Weaker US data and tighter policy equal a problem

a more dovish stance now

Source: Bloomberg and BNPP AM, as of 29/03/2019

Of course, we have to acknowledge that only China is actually easing – the other major central banks have merely paused or sounded more dovish. Nonetheless, it appears that central banks have engineered a goldilocks-type environment: inflation is still low, growth is soggy, but not collapsing, and therefore the threat of policy tightening is low.

This is an extract from the asset allocation quarterly by the MAQS team at BNP Paribas Asset Management.

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BNP Paribas AM

BNP Paribas AM

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