Monetary tightening is slowly broadening out from the US across to a range of other developed economies. This represents a significant change from the looser policy environment of the past decade.
There are two elements to tighter policy. First, central bank balance sheets will no longer expand. Second, interest rates will probably rise very slowly.
This is positive from the perspective that it reflects a normalization of the world economy after the prolonged disruption of the Global Financial Crisis. Central banks around the world are recognizing that the global economy is on sound footing.
The immediate focus is on the US Federal Reserve which is set to announce plans to reduce the size of its balance sheet. This will be a gradual process, starting at $10bn per month and rising to $50bn by the end of 2018. At this pace, it will take around four years until the size of the Fed balance sheet is back to normal. The process is set to run on autopilot, without sensitivity to short-term fluctuations of the economic cycle, which might be useful considering the uncertainties surrounding the future make-up of the Fed policy board.
Even though the European Central Bank is set to cut back on asset purchases in 2018, it will probably not stop altogether until 3Q 2018. At that time the balance sheet of the G3 central banks will start to shrink, as Fed cuts will be larger than Bank of Japan buying (which has already faded).
The ECB could hike interest rates by the end of 2018. Japan is much further behind in the process, which reflects the struggle to pull inflation away from zero.
The focus is not just on the balance sheets of G3, but also on interest rate hikes in other developed economies. Canada has already put through two rate hikes since July, while Sweden and Australia will probably move in around six months. Even the UK is hinting at an imminent rate hike, despite Brexit uncertainties.
Some nay-sayers have expressed their view that markets are due for a correction since interest rates will head higher and Central Bank balances will shrink, hence, there won’t be as much liquidity. However, the overall news is not new. As early as 2016, there was already talk of a series of rate hikes. The pace of tightening is likely to remain very gradual. Economic growth is increasingly robust. This means that central banks want to show prudence, and slowly guide policy towards neutral settings, but they do not need to act with any urgency. The Fed has signaled its intentions on their balance sheet well in advance, so market has most likely priced in the monetary tightening already.
Even though the speed will be slow, the direction is clear. The US markets continue to head higher and in many days set records for all-time highs on the S&P 500 and the Dow Jones Industrial Index. This price action will most likely continue since the markets have already priced in the future interest hikes. We also expect European and Japanese stock markets to follow suit and head higher just like US markets have.