Global central bank actions shouldn’t derail the Fed’s plan to raise rates next year, but the hikes will likely be gradual, says Morningstar’s Bob Johnson.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.
We had some big moves out of the European Central Bank this week, but how will it impact the United States and the Federal Reserve? I'm here today with Bob Johnson, our director of economic analysis, for his take.
Bob, thanks for joining me.
Bob Johnson: Great to be here.
Glaser: Let's start with the European Central Bank. A surprise move from them this week. Can you tell us what they did and what they are trying to accomplish?
Johnson: They took a number of steps--and this follows up from some steps they took this summer already--to really ease things off a little bit. The reason they felt this is all necessary is because, if you recall, their inflation rate on not a month-to-month but a year-over-year basis came down to 0.3%, which is dangerously close to deflation. On top of it, their GDP growth in the second quarter came to a dead halt after three quarters of at least some improvement coming out of the recession; it stalled out again. That's got them very worried.
And [Thursday], they came out with guns blazing. They cut a couple of key interest rates. They cut the overnight lending rate. On the other side, bank money that is held at the central bank as a reserve, they're now charging negative 0.2% instead of negative 0.1%. That certainly encourages banks to lend out the money rather than pay a penalty fee, if you will.
Each one of them normally would have been considered a big step, but combined, it's pretty powerful. And on top of it, they announced they'd buy some asset-backed securities and some covered bonds as well, which, in essence, encourages corporate lending and encourages businesses to borrow. Those are all things meant to stimulate the economy.
And this follows up their moves earlier this summer, some of which hadn't even been implemented yet. There were some lending programs that were going to kick in this month and next month, and we haven't even seen the results, but things got so dire that I think they had to move a little bit faster.
Glaser: With these moves, ECB head Mario Draghi says that rates are now basically at their lower bound. Their asset purchases are constrained by some political and charter issues; they can't buy sovereign debt like they did in the U.K. and in the U.S. So, the question is, is this enough? Will this actually work? Or is the ECB really just doing all they can, but it's not going to make a big dent?
Johnson: They're doing everything that they can, and as you mentioned, they do have structural limits. Although, they've said about two times earlier that they'd reached the lower bound, and somehow they managed to find a little bit more in their pocket.
But I really think there isn't a lot left. I think this will help. The mechanism where all of this helps is a little different than in the U.S. market, where low rates are meant to stimulate assets and encourage the housing market. [In the EU], what it really does is push the euro lower and make European goods more competitive in the rest of the world; that's the real benefit that they'll get from all of this. The euro was pushing 1.5 to the U.S. dollar. [Thursday] it closed below a historic point at 1.3. Some analysts out there--I don't know that I agree--think the euro will be back to parity in two or three years. So, clearly the euro has come back down, and that will make them more competitive. That is a piece of the good news for them.
Now on the other hand, … what the ECB is trying to do is buy time, so that structural reforms that they need actually get made--and so far they haven't been made. France's tax policies clearly need to be changed. Italy has some labor reforms and some other things that they need to do that they haven't taken action on yet. And even Germany--yes, they are doing very well, thank you--but their own internal demand is not so hot, and they could do more to stimulate that, which would help the rest of the union.
<TRANSCRIPT>
Glaser: We heard from the Bank of England this week as well. The U.K. is growing at a much faster rate than the eurozone. Are they still on track to raise rates potentially early next year?
Johnson: Everybody is watching the U.K. closely, because they've been particularly strong. Their economy grew as much as 3.5%--clearly a pretty nice rate of growth there--and they are worried about when will the withdrawal come? They met Thursday, and they decided to hold rates steady for now, and said the one other thing they're watching is inflation-adjusted wages. Those haven't done much yet, so people are thinking, maybe … we'll get a few more months of low rates out of the U.K.
They've also engaged in a quantitative easing program because they have their own currency, as does the U.S., so they've got more flexibility, and they've really used it. Their economy is beginning to heat up, especially the housing market in London, and that's starting to cause some pressures to raise rates, and I think they will go first. And when they go first, people will be quickly asking how soon the U.S. Fed will follow suit?
Glaser: The Bank of Japan has been very aggressive as well. We got a little bit of data from them. What do you expect them to do at their upcoming meeting?
Johnson: They are meeting on the 9th, and there are some economic forecasts that go underneath all of this, and they continue to think that the stimulus they've put in place is slowly working. I'm not so sure that I believe that, because working at cross purposes, they raised their consumption tax pretty drastically, and that certainly had a huge impact on the second quarter, and the July numbers don't look a lot better yet. But they are holding the faith, and they are going to continue with their current policies based on the data and forecast that they released Thursday.
Glaser: How does this impact the United States and the Fed--Janet Yellen or rest of the board? How much do they consider what these other banks are doing when setting their policy rate? Or are they really just looking at what's happening with the economic data here in the United States?
Johnson: I think the formal charter is to watch what's happening in the U.S. and adjust for U.S. inflation and labor rates all at the same time. And I think they'll continue to watch the labor data very, very closely.
On the other hand, if the rest of the world is falling apart, it would be self-defeating for the world economy for them to drastically raise rates. It doesn't help the rest of the world if our demand goes down all of the sudden. Right now, we are the main engine in town. The U.S. economy is very strong. We can talk more about that later, but the U.S. economy really is the engine for a lot of things to come out of the recession, and we certainly have begun to see that in some categories.
Glaser: Let's look at that strength then. What data have we seen recently that could lead to the Fed raising rates or being more comfortable raising rates next year?
Johnson: They are watching the labor market, so we'll see what happens with the employment report later this week and some of the other data--what the hourly wage did and so forth. But just looking at the overall strength of the economy, labor market or not, the ISM Services Index released on Thursday showed a pretty dramatic increase. Everybody thought it was going to go down. And people thought auto sales would go from 16.4 to 16.6 million [annualized] in August; they went to 17.5 million.
Now, these numbers can all be adjusted--we know the danger of watching individual numbers--but these are kind of "on-fire" type of numbers. And so I think they are bullish about the U.S. economy and suggest that maybe rates here will be going up sooner than later.
The Fed will meet next week, and I think they'll just reaffirm that the bond buying is all done; it was already scheduled to wrap up in October, and I think that will be finalized at the meeting. But I still think they are going to be very, very, very vague about when they are going to begin raising rates. And as I've said many times, I really don't care if it is February or if it is October. I think rates belong slightly higher, but for a lot of the reasons we've talked about again and again, less corporate demand, aging baby boomers, lower inflation rates, I am not expecting a big boom in interest rates. Yes, I expect them to move higher, but not the kind of destructive doubling in rates that we've seen in other recoveries.
Glaser: Bob, I certainly appreciate your analysis on what's happening with central banks today.
Johnson: Thank you.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
