The Great Decoupling: Central Banks Fall Out of Step on Inflation Policy
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The Great Decoupling: Central Banks Fall Out of Step on Inflation Policy

Illustration by IIResearch

Switzerland blinked first. In March, the Swiss National Bank kick-started a rate cutting cycle, becoming the first central bank overseeing the world’s 10 most heavily traded currencies to lower rates for the first time since November 2020. It joined counterparts in Latin America and other emerging markets that have been speeding up rate cuts as the threat of inflation has eased. In February, the Bank of China cut its five-year loan prime rate – the largest cut of its kind on record – to come to the aid of real estate developers struggling with debts. But it was the Swiss cut that got analysts excited.

"We've got a rate cut now in the G10, with the Swiss National Bank being the first out the gate," said Guy Miller, chief market strategist at Zurich Insurance Group. "So, we have got some evidence now to say that the central banks are acting as opposed to just talking – policy has indeed pivoted."

Not everyone is talking about a pivot. As Switzerland was announcing rate cuts, the Bank of Japan made the seismic decision to raise interest rates for the first time in 17 years. Six other central banks in the G10 – including the US Federal Reserve and the European Central Bank – held rates steady in the first quarter of 2024 as economic data came in stronger than expected. Instead, many are talking about an unprecedented decoupling in global interest rates as developing nations dealing with falling inflation are refusing to wait for the Fed, the ECB or the Bank of England to cut rates. Dominic Bokor-Ingram, senior portfolio manager for emerging and frontier markets at Fiera Capital told Reuters last year: "We have never seen this on a kind of global level… we've seen lots of decoupling from the Fed, but we have never been able to add up emerging markets and add up developed markets, and come to this conclusion.”

Low inflation was the defining problem of the last decade – a problem swiftly reversed by the end of 2022, when just about every country in the world was grappling with soaring price rises. That problem is abating, but progress is slow and the results uneven. On the one hand, in the US, institutional investors are getting used to the idea that inflation isn’t going away any time soon. Real estate and private equity assets are looking less attractive, since financing is more expensive. Fixed income strategies are being revisited. Three quarters (77 per cent) of the 100 US-based Institutional Investors polled by CoreData, a financial services firm based in London, said they expect interest rates to remain elevated in 2024 – a sign that investors will be cutting down on their risk exposure.

Meanwhile, business leaders in Japan are celebrating the return of “normal” economic policies after more than a decade of intervention. No other central bank pursued quantitative easing with quite the same vigor as the Bank of Japan, which ended up buying 50 per cent of Japanese government bonds, alongside corporate bonds, equity index exchange traded funds and Japanese real estate investment trusts. Then, in March, the Bank of Japan officially ended its commitment to buy an unlimited amount of Japanese government bonds and abandoned its yield curve control policy, which had aimed at capping the 10-year yield at 1 per cent. Kazuo Ueda, the governor of the Bank of Japan, said that Japan’s “extraordinary monetary easing scheme” was over.

The short term impact is likely to be limited. The Bank of Japan had been trailing the move for several months, so markets had already priced in the move. And rates are still low compared to international standards. But business leaders still found the moment symbolic. “The opportunity for Japanʼs economy to break out of the protracted stagnation of the so-called ‘thirty lost years’ has finally arrived,” Hironori Kamezawa, chief executive of Japan’s biggest bank Mitsubishi UFJ Financial Group, told Institutional Investor earlier this year. “As Japan returns to a positive interest-rate environment, weʼll strengthen the profitability of our balance sheet and make this a year of capturing growth benefits.”

On the other side, Switzerland joins central banks in Brazil, Colombia and Czech Republic, which have all been cutting rates in 2024 – some for the first time in years. In March, Mexico’s central bank cut interest rates for the first time since 2021. In much of Latin America, there is simply more to cut. Latin American central banks are attuned to inflation figures. Many countries in the region have suffered hyperinflation that has made them sensitive to the risks of delaying action. When prices started rising during the coronavirus pandemic, many were decisive in raising rates ahead of more advanced economies. Brazil and Mexico announced rate rises in 2021, while Chile, Colombia and Peru followed later in the same year. It wasn't until 2022 that the US Federal Reserve and the European Central Bank followed suit.

Now these countries are cutting ahead of the Fed, there are some short term gains to be had. Uneven global interest rates have been shown to benefit emerging equities, according to analysis by UBS. Historically, in the first six months after an emerging market eased monetary policy ahead of the Federal Reserve, equities offered strong and front-loaded returns of 7 per cent in the local currency, UBS strategist Manik Narain has shown. Only government bonds could match these returns, with yields declining by 80 basis points on 10-year benchmark issues in the six months after an emerging central bank cut rates, which resulted in total returns of between 8 and 9 per cent.

In the longer term, investors have one eye on perhaps the most significant difference in monetary policy: between the US and China. In March, the US consumer price index was expected to show that prices continued to rise stubbornly at 3.4 per cent year on year, higher than the 3.2 per cent rate measured in February, figures that suggest the Fed’s 2 per cent goal is still out of reach. In China, while recent data have been more encouraging, consumer price inflation fell 0.8 per cent in January, its steepest drop in over 14 years, as the country grappled with persistent low growth. This kind of decoupling – especially between powerhouses the size of China and the US – brings the global economy into unchartered waters. And it suggests there is more going on than a different set of policies.

For decades, China has been the world’s factory, pumping goods into supply chains that became the life blood of markets. The US became its largest buyer, and the two countries continued to grow in this mutually supporting cycle. But after the US-China trade war began in 2018, Chinese exporters were forced to rethink their business. Many decided to set up manufacturing in Mexico, where finished factory goods could be sent over the land border to the US and they would be selling alongside American companies anxious to bring manufacturing closer to home. Tesla’s plans for a reported $5 billion factory in northern Mexico alone has been credited with attracting $1 billion in Chinese investments to nearby industries. For governments, too, nearshoring has become an increasingly important answer to the uncertainty plaguing supply chains. In November, President Biden set up a taskforce to focus solely on maintaining a flow of goods, including essential shipments of pharmaceuticals and food.

While the nearshoring of supply chains and divergent inflation sound like two separate issues, in fact they are linked: a 2024 study by the ECB showed that nearshoring of some production by the euro area was inflationary – and that if trade partners retaliated, that inflation would be stronger and longer. That may be one reason why Janet Yellen was so keen to emphasize, on landing in China in April, that the US does not seek to decouple from China. “Our two economies are deeply integrated and a wholesale separation would be disastrous for both,” she said. Yellen and other politicians have accepted that some elements of the tech ecosystem between China and the US have to cut ties. There are fundamental concerns about the impact of the convergence of technology between Beijing and Washington, and the impact of this on global security.

But finance binds the two nations together. Beijing owes more than $900 billion of US government debt, making it America’s largest creditor save only for Japan. Many US financial institutions have benefitted from easing financial reforms in China. Corporate enterprises from cars to consumer banks have set up shop on the mainland, hoping to benefit from the predicted rise in consumer spending. There are signs that some may be eying an exit: last year, II reported on the news that Vanguard was exiting from China, a decision that could give internal political cover to other asset managers that want to pull out. Nonetheless, many companies have plugged millions of dollars into mainland ventures and are holding out for returns. Yellen’s comments show that neither side believes it can afford widespread economic decoupling. But the unlevel playing field shows that uncertainty – and inflation volatility – is here to stay.

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