GLOBAL CENTRAL BANK WATCH

GLOBAL CENTRAL BANK WATCH How far will interest rates rise? The neutral level of interest rates in most economies is much lower than in the past However, we expect the US Fed funds rate to rise temporarily above this rate Meanwhile, we think more central banks will ease than tighten policy by year-end th Sep. 1 The peak rate of interest in the next tightening cycle is likely to be lower than in the past. Indeed, we estimate that the so-called neutral rate is now only around % in the US and UK and substantially lower in the euro-zone and Japan. Partly for this reason, policy rates will probably remain very low in the coming years in most advanced economies. However, we still expect the fed funds rate to rise further and faster than the markets expect next year. From when? to how far? The US Fed s decision to leave interest rates at their emergency lows this month has prompted us to tweak our forecasts for US monetary policy. We now think the Fed will hike rates just once this year, probably at its December meeting. But regardless of when it makes its first move, investors attention will soon shift to the question of how far and how fast interest rates will rise, not just in the US but elsewhere too. A key factor in gauging how far rates will rise in the coming years is to consider what the neutral or equilibrium rate of interest is. This is the interest rate that would prevail if inflation is in line with the central bank s target and the economy is at full employment. This rate appears to have fallen steadily in advanced economies since the early 1s. Chart 1 illustrates this by showing that average real interest rates have fallen steadily for the past three decades in four major advanced economies. Similar charts could be drawn for each individual country, suggesting that global rather than national forces are at play. Central bankers have been stressing for some time that the neutral rate of interest is probably lower now than in the past. The US Fed s latest projections point to policy rates settling at around.% over the longer run. And in a recent speech the Governor of the Bank of England, Mark Carney, said he expected UK policy rates to rise to a level in the medium term that is perhaps about half as high as historical averages which he identified as meaning around.%. 1 CHART 1: REAL INTEREST RATES IN ADVANCED ECONOMIES (%) Simple average of key policy -1 rates minus annual CPI inflation -1 for Germany, Japan, UK and US. - - 1 1 1 1 1 1 Sources Thomson Datastream, Capital Economics Given that the inflation target in both the US and UK is %, this implies that the Fed thinks the neutral real rate of interest is 1.% while Mr Carney believes it could be as low as.% in the UK. As Chart shows, these rates are both higher than their current levels, but they would still be below the average rates seen since 1. CHART : REAL INTEREST RATES* IN US & UK (YR. AVE.) 1 Averages Since 1 UK US - - - - -1 1 1 17 17 1 1 1 1 1 Source Thomson Datastream *Policy rate minus CPI inflation 1 1 - - - - -1 Global Central Bank Watch 1

Four reasons for neutral rates to be lower Looking ahead, we think four factors are likely to keep the real interest rate required to balance saving and investment lower than it has been for most of the past few decades. First, desired investment will probably be weak because expected GDP growth is now low: this in turn is mostly due to population aging and weak productivity growth. Second, credit spreads will probably be higher than before the financial crisis due to the greater cost of financial intermediation and perhaps also because perceptions of risk may have increased since the global financial crisis. Higher credit spreads imply that the policy rate will need to be lower than otherwise. Third, although households in advanced economies have deleveraged to varying degrees since the financial crisis, they are unlikely to releverage rapidly given that memories of the crisis remain fresh. In other words, precautionary savings will probably remain high. On top of this, if households expect consumption growth to be slower than in the past, they are likely to save more of their income for the future. And fourth, aggregate saving rates in many emerging economies, including China, are likely to remain high in the coming years. Indeed, it is notable that savings have not fallen during the past year or two despite the impact of the slump in oil prices on savings in OPEC and other oil-exporting countries. (See Chart.) To be clear, saving rates in emerging economies may well fall over the longer term as, for example, China s population ages but this will probably take effect only over a decade or longer. The net effect of these forces will be to keep desired savings relatively high and desired investment relatively low by past standards. That in turn will tend to keep real interest rates low. While there is no precise way to quantify these effects, our best guess is that the neutral real rate in both the US and UK has fallen to around 1%. (See our US Economics Focus, Is the neutral interest rate now lower?, published 7 th July 1.) And in the euro-zone and Japan, the neutral rate may be closer to zero, or possibly even negative. 1 CHART : SAVINGS IN EMERGING ECONOMIES (% GDP) 1 1 Source IMF World Economic Outlook The implication is that, with an inflation target of %, the neutral nominal interest rate would be around % in the US and UK, and substantially lower in the euro-zone and Japan. US interest rates likely to overshoot Even if the neutral rate is lower than in the past, interest rates may still need to rise sharply during the coming year or two in the US. The unemployment rate looks on track to fall well below the natural or non-accelerating inflation rate estimated by the Congressional Budget Office. (See Chart.) As a result, our forecast is for inflation to exceed the target over the coming year or two, forcing the Fed to raise rates above the neutral rate in order to bring it back towards %. 1 7 CHART : US & UK UNEMPLOYMENT RATES (%) UK US Dotted lines show official estimates of unemployment rate consistent with full employment CE Forecast 7 1 11 1 1 1 1 1 17 1 Sources Thomson Datastream, CBO, OBR, Capital Economics In the UK, we expect inflation to rise much more gradually than in the US because there is still a lot of fiscal austerity to come and the unemployment rate is likely fall more slowly because there is 1 1 7 Global Central Bank Watch

greater scope for a rebound in productivity. This in turn implies that the policy rate should rise only slowly towards its neutral level too. Finally, there is little prospect of rate rises in Japan or the euro-zone. Both economies are too weak to generate a significant rise in inflationary pressure and in both cases precautionary savings are likely to be comparatively high and desired investment comparatively low. Indeed, we expect both the ECB and Bank of Japan to loosen policy further before the end of this year. Michael Pearce and Andrew Kenningham + () 7 7 / Review of recent policy changes Since our last Global Central Bank Watch, seventeen of the twenty central banks we cover have held policy meetings. Only two, the Reserve Bank of New Zealand and the Norges Bank, cut rates and none have hiked. (See Chart.) The US Fed left policy unchanged at its meeting on the 17 th of September. In the subsequent press conference, Janet Yellen suggested that the recent market turmoil in China lay behind its decision. The Bank of England also left rates on hold again and only one member of the Monetary Policy Committee voted to raise rates. Elsewhere, both the Bank of Japan and the ECB left policy unchanged. - - - -1-1 -1 CHART : CHANGES IN BENCHMARK RATES Rate hikes Rate cuts Number of rate changes per month by the twenty central banks covered in this publication 7 1 11 1 1 1 1 - - - -1-1 -1 Among the smaller advanced economies, the Reserve Bank of New Zealand (RBNZ) and the Norges Bank both cut rates. The RBNZ cut its cash rate by bp for the third consecutive meeting in an acknowledgement that the economy has slowed sharply. Its statement also highlighted that some further easing seems likely. The Norges Bank cut its key policy rate to.7% as lower oil prices continue to weigh on its economy; it, too, signalled that further loosening may be required. The Reserve Bank of Australia, Sweden s Riksbank and the Bank of Canada all kept policy settings unchanged, as did the Swiss National Bank. None of the emerging economy central banks covered in this publication changed policy settings over the past month. Brazil s central bank kept the Selic rate at 1.%, despite the recent slump in the real. With Brazil s economy in recession and inflation high, the Bank s monetary policy committee suggested that rates will not be raised any further. Having cut rates at each of its previous meetings this year, the Central Bank of Russia also decided to keep policy on hold in September, highlighting concerns about the impact of the recent depreciation of the ruble on inflation. Central banks in Mexico, Poland, Turkey, South Africa and South Korea all left policy on hold over the past month or so whilst the People s Bank of China and Reserve Bank of India have had no rate-setting meetings. What s next? Before the end of the year, we expect nine of the twenty central banks covered in this publication to ease monetary policy and only three to tighten. (See Table 1 overleaf.) Stubbornly low inflation will probably push policymakers in the euro-zone, Japan and Sweden into easing policy. Downward revisions to the ECB s inflation and growth projections combined with a dovish statement by President Draghi have persuaded us that the ECB will step up the pace of its asset purchases soon. This could mean an increase from bn to bn per month, possibly as early as its nd October meeting. Meanwhile, the Bank of Japan will probably raise the annual Global Central Bank Watch

pace of its asset purchases from the current tn to tn at its late-october meeting. TABLE 1: SUMMARY OF CE FORECASTS FOR REST OF 1 Policy Direction Easing No Change Tightening Economies Australia, Canada, China, Euro-zone, Japan, Sweden, Switzerland, New Zealand, India UK, Denmark, Norway, South Korea, Mexico, Poland, Russia, Brazil US, South Africa, Turkey most likely on th September. (See our RBI Watch, Another rate cut likely, th September.) CHART : POLICY RATE IN END-1 IMPLIED BY CE FORECASTS & OIS RATES (%)... 1. 1... -. -1. -1. CE Forecast Implied by OIS rates.. 1. 1... -. -1. -1. Source Capital Economics A resumption of upward pressure on the Swiss franc seems likely if the ECB announces an acceleration of its asset purchases. This would probably push the Swiss National Bank to cut its deposit rate, perhaps as soon as December. The continued fall in commodity prices is likely to force policymakers to cut rates further in Australia, Canada and New Zealand this year, and in Norway in the first half of next year. The only major central banks in advanced economies which we think will tighten policy before the end of next year are those in the US and UK. We now expect the US Fed to make its first move in December, although lingering fears of a hard-landing in China or another stand-off in Congress over the debt ceiling may yet prompt another delay. We still anticipate that rising wage and price inflation next year will force the Fed to tighten policy much more aggressively than markets currently expect. (See Chart and our US Economics Update, Fed delays rate hike yet again, 17 th September.) In our view, the Bank of England can afford to be more patient in normalising rates because there is greater scope for a rebound in productivity in the UK, which should keep inflation lower. Among emerging economies we expect the People s Bank of China to cut its benchmark rates and lower reserve requirements further before the end of the year as policymakers focus has shifted towards supporting the economy. We also expect the Reserve Bank of India to cut its policy rates, The central banks in South Africa and Turkey, whose economies are particularly vulnerable to Fed tightening, are set to hike rates in the coming months. We expect the Reserve Bank of South Africa to do so in November in order to counter the inflationary impact of depreciation of the rand. And, in Turkey, market interest rates, which currently hover around the overnight lending rate will probably need to be raised by around bp over the next six months. (See our Emerging Europe Update, Turkish MPC slowly taking a more hawkish line, nd September.) Central banks in most other major emerging economies are set to keep policy unchanged. The central bank of Poland can afford to stick to its highly accommodative policy stance for the time being. Similarly, the Central Bank of Russia is likely to keep its key policy rate on hold to the end of this year and, despite is economy being in recession, the central bank of Brazil will probably do the same. Having said that, the real has tanked since the last COPOM meeting, so further tightening cannot be ruled out. Concerns over high debt levels are likely to mean that South Korea also keeps policy unchanged and Mexico is also likely to leave policy unchanged. Melanie Debono + () 711 11 Global Central Bank Watch

TABLE 1: CENTRAL BANK POLICY RATES Country Policy rate Latest Last Change Major Advanced Economies US Fed funds target -. Down 7bp (Dec. ) Next Change (CE Forecast) Up to.-.% (Dec. 1) End-1 End-1 End-17.-. 1.7-..-. Euro-zone Refinancing rate. Down 1bp (Sep. 1) None on horizon... Japan Overnight rate -.1 Down bp (Dec. ) None on horizon -.1 -.1 -.1 UK Bank Rate. Down bp (Mar. ) Up bp (Q 1). 1. 1. Other Advanced Economies Canada Overnight target rate. Down bp (Jul. 1) Down bp (Dec. 1)... Australia Cash rate. Down bp (May 1) Down bp (Nov. 1) 1.7 1.. Switzerland m Libor target -.7 Down bp (Jan. 1) Down bp (Dec. 1) -1. -1. -. Sweden Repo rate -. Down 1bp (Jul. 1) Down 1bp (Oct. 1) -. -. -.1 Denmark Deposit rate -.7 Down bp (Feb. 1) Up 1bp (Q 1) -.7 -. -. Norway Sight deposit.7 Down bp (Sep. 1) Down bp (Q 1).7.. New Zealand Cash rate.7 Down bp (Sep. 1) Down bp (Oct. 1)... Major Emerging Economies China 1m deposit rate 1.7 Down bp (Aug. 1) Down bp (Oct. 1) 1. 1. 1.7 India Repo rate 7. Down bp (Jun. 1) Down bp (Sep. 1) 7. 7. 7. Brazil Selic rate 1. Up bp (Jul. 1) Down bp (Q 1) 1. 1. 1. Russia 1-week repo rate 11. Down bp (Jul. 1) Down bp (Q1 1) 11. 1. 1. Mexico Overnight target rate. Down bp (Jun. 1) Up bp (Q1 1)... South Korea Base rate 1. Down bp (Jun. 1) Up bp (H 1) 1. 1.7. Turkey O/night lending rate 1.7 Down bp (Feb. 1) Up 1bp (Q1 1) 1.7 1. 1. Poland Reference rate 1. Down bp (Mar. 1) Up bp (H1 17) 1. 1.. South Africa Repo rate. Up bp (Jul. 1) Up bp (Nov. 1). 7. 7. Global Central Bank Watch

TABLE : UNCONVENTIONAL POLICY AND FORWARD GUIDANCE (SELECTED ECONOMIES) Central Bank Current Policy CE Forecast of Future Changes Federal Reserve Bank The Fed ended its asset purchases in October 1 and since March has stated that it would not raise rates until there had been further improvement in the labour market and it is reasonably confident that inflation will move back to percent over the medium term. Once the Fed begins raising interest rates, which we expect to be in December this year, the FOMC is likely to state that it expects the federal funds rate to be raised only gradually. European Central Bank Since March 1, the ECB has been purchasing bn of assets per month. Its intention is to continue doing so until September 1 and until there has been a sustained adjustment in the path of inflation. We think that inflation will remain well short of the ECB s goal of below but close to %. In light of this, the ECB is likely to increase the pace of its asset purchases from bn to bn per month, possibly as early as its next meeting in October. We also expect it to extend its QE programme beyond September 1. Bank of Japan In October 1, the Bank of Japan stepped up the annual pace of its asset purchases under its policy of Quantitative and Qualitative Easing from -7 trillion to trillion. The vast majority of purchases are of JGBs. We think the BoJ is likely to increase the annual pace of its purchases again, from trillion to trillion, at its end-october meeting. Bank of England The BoE has stated that when interest rates begin to rise they are expected to do so more gradually and to a lower level than in recent cycles. It also pledged not to start actively selling gilts until Bank Rate has risen to a level from which it could be cut materially if the economy weakened again. The BoE now places much less emphasis on formal forward guidance than it did in 1-1. Nonetheless, it will probably update its guidance when it first raises rates to emphasise that it expects tightening to be gradual. It is likely to start selling gilts back to the market in 17. Swiss National Bank In mid-january, the SNB removed the ceiling on the Swiss franc, by which it had capped the currency at CHF1. per euro since September 11. Its latest policy statement reiterated its willingness to intervene as required in the foreign exchange market. The SNB has already cut the centre of its target range for Libor to minus.7% and we suspect it will cut it to minus 1.% before long. Policymakers will probably intervene again if the currency appreciates back towards parity with the euro. In a series of decisions since February, the Riksbank has reduced its policy rate from % to -.% and announced a total of SEK1bn (.% of GDP) of bond purchases to Riksbank take place this year. Furthermore, the bank emphasises (Sweden) that it is prepared to rapidly make monetary policy even more expansionary, even between the ordinary monetary policy meetings, if this becomes necessary. Sources Central bank websites, Capital Economics We suspect that upward pressure on the krona will prompt the Riksbank to cut its policy rate and step up its purchases of government bonds. The Riksbank has said that it may consider other options such as purchases of alternative securities or FX intervention. Given the small size of the bond market we think it is likely that these steps will need to be taken. Global Central Bank Watch

TABLE : CALENDAR OF POLICY DECISIONS UP TO MID-NOVEMBER Date Economy Policy Instrument Prior Survey CE Forecast th September India Repo rate 7. 7. 7. th October Australia Cash rate... th October Poland Reference rate 1. - 1. 7 th October Japan Annual rise in monetary base tn - tn th October UK Bank Rate... 1 th October South Korea Base rate 1. - 1. 1 st October Turkey Overnight lending rate 1.7-1.7 1 st October Canada Overnight target rate... 1 st October Brazil Selic rate 1. - 1. nd October Euro-zone Refinancing rate. -. th October Sweden Repo rate -. - -. th October US Fed funds target -..-.* -. th October New Zealand Cash rate.7.. th October Mexico Overnight rate. -. th October Japan Annual rise in monetary base - - tn th October Russia 1-week repo rate 11. - 11. rd November Australia Case rate - - 1.7 th November Poland Reference rate - - 1. th November Norway Sight deposit.7 -.7 th November UK Bank Rate - -. 1 th November South Korea Base rate - - 1. 1 th November Japan Annual rise in monetary base - - tn 1 th November South Africa Repo rate. -. *Bloomberg Survey was taken on th September Global Central Bank Watch 7