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March 31, 2022

More central bank action but BOJ swims against the stream

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Julius Probst
Arnaud Lieugaut
Patrick Malm
Karl-Philip Nilsson
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Central bank policy rates

Using data from the Bank for International Settlements, we created a dashboard displaying changes to central bank policy rates over the last year. It clearly shows we’re in the midst of a major global tightening cycle. Central banks across emerging markets (EMs) have seen their currencies depreciate against the dollar while also experiencing high inflation rates. In anticipation of the Federal Reserve tightening that has just begun, EMs have been forced to increase their own policy rates in recent months to ward off further inflationary pressures and currency depreciations.

Here’s another way to visualise central bank activity. This chart compares the net balance of policy hikes against cuts from 115 central banks. As you can see, the number has recently turned positive, meaning an increasing number of central banks are now tightening monetary policy.

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US yield curve as predictor of recession?

As we noted in 2019, an inverted yield curve often indicates an overly tight monetary policy, when the Fed has hiked the policy rate above neutral.

However, conditions behind the current yield curve inversion are slightly different: the US is experiencing high inflation, but the Fed has yet to undertake any substantial tightening – though markets are expecting up to six more rate hikes this year, followed by cuts in 2023.

Bond traders now anticipate a severe economic slowdown or even recession by year end or beginning of 2023. The Fed must quickly bring down inflation without killing the economy – a tricky balancing act.

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Oil price decomposition

The New York Fed has a model that decomposes, or splits, the change in oil price into demand and supply components to see which one is driving the oil price. Its last report showed the most recent price rise was mostly due to an anticipated decrease in supply, and to a lesser extent, an increase in demand.

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Spread between Urals and Brent

This next chart shows the spread between the price of Urals – Russian oil exports – and Brent. Until January of this year, Urals traded at a relatively minor discount of only a couple of percentage points. Since the Ukraine war and the sanctions imposed on Russia, the spread has widened to as much as minus 25 percent.

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Japan inflation

Japan is the only major economy where inflation remains significantly below target. In fact, core inflation recently turned sharply negative, potentially indicating a big economic slowdown.

Rising energy prices have widened the spread between core and normal consumer prices, showing that current inflation is not demand-driven. Furthermore, the most recent measure of the output gap is also negative, meaning that the economy is operating below potential.

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‘Opportunistic reflation’

Consequently, the Bank of Japan (BOJ) decided to swim against the tide of global tightening to engage in a type of “opportunistic reflation.” It just reinforced its commitment to keep long-term yields low via yield curve control, which BOJ Governor Haruhiko Kuroda started in 2016.

So while the monetary base has now soared above 130% of GDP, 10-year yields remain between -0.2 to 0.2% thanks to the BOJ’s asset purchases.

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Yen USD exchange rate  

As a result of the BOJ’s policy easing, the yen fell against the dollar – now trading at around 124 compared to 110 just a few weeks ago.

To determine a fair value exchange rate between the yen and the US dollar, we created a model that incorporates the following variables:

  • Growth differential
  • Economic sentiment indicator differential
  • CPI differential
  • Yield differential
  • Money growth (M2) differential
  • Time trend variable

As you can see, the model’s predicted exchange rate tracks the actual exchange rate rather well.

You can also see the impact of the BOJ’s easing on the yen’s value against the US dollar. This will boost net exports and lead to higher imported inflation in the short run, consistent with the central bank’s target of 2%. In the longer run, however, we should expect the gap between actual and predicted value to narrow again.

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Japan’s Phillips curve looks like Japan

The Phillips curve is an established relationship in macroeconomic theory that shows the interaction between inflation and unemployment. Historically, a higher rate of inflation is associated with a lower rate of unemployment, but the relationship is far from stable. For example, a country’s topography could affect the curve…

Of course, that was just a joke – although, interestingly, the curve did really resemble the Japanese islands back in 2008, as Gregor Smith discovered – and which we replicated above. Happy April Fool’s Day!

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