By Nikola Kedhi.
December has been eagerly awaited by many market participants. It turned out to be the month of the Great Divergence between the Fed and the ECB. The central banks announced policy changes that, for the first time since the beginning of the crisis, moved in opposite directions.
On December 3rd, the ECB cut the deposit rate by 10 basis points, to -0.3%. ECB President, Mario Draghi, also declared they will extend their quantitative easing program until at least March 2017. The novelty was the inclusion of municipal bonds into the program. However, ECB will continue at their current buying rate of €60 billion a month. The markets were unimpressed: Mr Draghi had prepared investors for two months and expectations were too high. The euro increased immediately by 2.6%, while the Stoxx 600 closed the day down 3.1%.
Inflation in the Eurozone remains low. It is currently 0.1% and there is no sign that it could get the much needed boost any time soon. However, market analysts are confident that if the ECB continues down this path — and it certainly will — inflation will reach the 2% threshold before Draghi’s term ends. Notably, the ECB President faces quite a strong opposition from within the central bank. The more conservative officials do not feel comfortable with the new unconventional methods. The whole quantitative easing program and going deeper into negative rates is unchartered territory for all. So the recent decision is highly justifiable as it leaves the ECB room to do more while appeasing the conservatives. It is very likely that until inflation gets to the desired levels, quantitative easing will continue.
In the weeks following the ECB’s decision, European markets grew as they prepared for another central bank to make an announcement. On Wednesday, the Federal Reserve increased the fed funds rate by 0.25%, to 0.5%. This rate hike, the first in nearly a decade, means the economic recovery in the US is officially complete. Fed chairwoman, Janet Yellen, said that there has been an incredible recovery in the economy and is it expected to continue down this path. She mentioned that there is still room for improvement though.
During her speech, it was curious that the Fed chairwoman kept repeating the word gradual when referring to future increases. This likely means that the Fed will be monitoring how the economy, inflation and markets will react and then decide how to proceed with forthcoming monetary policy. Thus, we can deduce that future rate increases in 2016 are not a sure thing, although very probable.
Inflation remains an issue as it still remains low. This makes the rate rise even more peculiar. Inflation is 0.1% and estimates for 2017 and 2018 were revised down to 1.9%. However, Ms. Yellen explained that this low inflation is due to transitory factors. In the medium term it is expected to reach 2%. She added that monetary policy takes time to show its effects. If the Fed were to raise rates at a later time, there would be the possibility of an overshoot in inflation. On the other hand, business investment has been on the rise and overall growth has been moderate. The labor market has been performing quite well and is nearing full employment. So, it makes sense that they opted for a small rate increase now, while keeping inflation and other macroeconomic indicators under observation.
After a year full of financial turmoil coming from China’s instability, the uncertainty of US rates and geopolitical issues, it seems that markets are nearing year’s end in a somewhat stable state. At the very least, now that US rates finally went up, they will enter 2016 with one less uncertainty to worry about.