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Global economy: A tale of three central banks

Balazs Koranyi, Reuters Dec 10 2017, 21:52 IST
The European Central Bank (ECB) headquarters are pictured in Frankfurt, Germany, December 7, 2017. REUTERS/Ralph Orlowski

The European Central Bank (ECB) headquarters are pictured in Frankfurt, Germany, December 7, 2017. REUTERS/Ralph Orlowski

Three central banks, meeting on both sides of the Atlantic, will highlight the diverging fortunes of the world's biggest economies as they head into 2018 after an exceptionally tranquil year.

While the growth cycle in the United States may be close to peaking, the euro zone is just getting comfortable with its economic run and Britain is weighed down by Brexit uncertainty, suggesting that their monetary policies will be out of sync for years to come.

Indeed, the US Federal Reserve is all but certain to raise rates on Wednesday, likely predicting three more hikes for next year, even as the European Central Bank pledges on Thursday to maintain super-low borrowing costs and the Bank of England promises only very gradual increases over the coming years.

The US economy will start the new year in the perfect spot but that would suggest that the only way is down, and a range of issues from uncertainty over tax cuts to midterm elections and high turnover atop the Fed, cloud the outlook.

"The music will keep playing for another year or so, but be wary of what is next," BNP Paribas said. "In 2018, we think the US economy will see its best year in terms of economic activity since 2005 with the unemployment rate dropping to its lowest level since 1969."

"The turn of the cycle is in sight," it added. "We see the recovery as long in the tooth and believe that cycles do die of old age."

Indeed, the economy is likely to face capacity constraints as the labour market tightens, pushing core inflation to the Fed's target and raising prospects of overheating if a tax proposal, now in Congress, substantially increases deficit spending. A big tax cut under discussion would - potentially - boost growth, and likely push the Fed to tighten more quickly.

"Better growth would increase downward pressure on the unemployment rate and upward pressure on inflation," Bank of America Merrill Lynch said. "Hence the Fed would respond with a modestly steeper path of monetary policy." The euro zone economy is in a similarly sweet spot but the growth cycle is still relatively young and only now beginning to broaden out so the ECB will remain reluctant to give up support. "The ECB faces the best of the possible outlooks in years: the moderate expansion phase is set to continue in 2018 and 2019, with limited risks of a setback, absent signs of excesses in demand wages dynamics and in leverage," Intesa Sanpaolo said in a research note.

The ECB is not in a hurry to alter communication both on asset purchases and interest rates," it added. Indeed, after an October stimulus cut that actually loosened rather than tightened financial conditions, the ECB will likely say it is content with the reaction, suggesting it will not revisit its stance for some time. It will also unveil initial 2020 inflation projections, which will likely show price growth at or just below target, rising only gradually over the coming three years, another argument not to take support away just yet.

Meanwhile, the Bank of England will have to tread a fine line between sounding like more rate hikes are coming and not squashing growth that economists think may slow to around 1.3% next year from 1.5% in 2017.

Uncertainty over Brexit, low wage growth and weak productivity are weighing on the economy but the BoE is not keen to see the pound weaken and add to an inflation rate that is expected to exceed its 2% target over the next three years. Although Britain appears to have cleared a key hurdle in Brexit talks and focus can now move to a discussion of a trade agreement, slow progress so far suggest that uncertainty will remain high and even if an eventual deal is likely, its terms will not be clear for some time.

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