Recent reports show that economic growth remains slow in major countries throughout the world, a trend that can give investors clues about future decisions of central banks. Japan, for example, registered a 1.9% increase in its gross domestic product (GDP) in the third quarter, while the eurozone posted only a 0.1% increase in GDP, a slight deceleration from the 0.3% pace in the second quarter. The slow pace of economic growth, which appears to be slowing, in the context of very low inflation, gives major central banks room for implementing more expansionary monetary policies.
What types of policies, especially since policy rates are near zero? Central banks seem keen on using forward guidance. That’s just a statement about how long they expect to keep rates low. In the U.S., the forward guidance is stated in terms of thresholds: 6.5% unemployment and 2.5% projected inflation. In the United Kingdom, it’s stated in terms of a 7% unemployment rate. In Japan, it’s stated in terms of the goal of 2% inflation. Until these thresholds are crossed, short-term rates are likely to stay low. The European Central Bank (ECB) could do something similar to give more clarity about how easy policy will be and for how long.
The ECB could also use tools like long-term refinancing operations, which are ways to lend money to banks for up to three years at favorable rates. Cheap financing will hopefully result in more lending. The last time this was tried, however, it didn’t work so well. The eurozone banks are too busy shedding assets (that is, cutting their loan portfolios) to bother with making more loans. It will take the cooperation of bank regulators to make monetary policy effective in the eurozone. That could happen this upcoming year as they move toward a more unified bank regulation framework.
In the U.S., unit labor costs—an excellent leading indicator of inflation, or lack of inflation in this case—declined 0.6% in the third quarter. For the past 12 months, unit labor costs increased 1.9%, a low rate of growth that points to continued low inflation. If the Federal Reserve wants to do more to help the economy, it can likely do more by buying less: It doesn’t take more asset purchases, but probably a change in its commitment to keep the federal funds rate at zero until the unemployment rate falls to 6% instead of the current threshold of 6.5%. This change in guidance would likely come at the same time as an announcement of the reduction in the pace of asset purchases, offsetting what they take (a reduction in purchases) by what they give (keeping rates low for longer).
Globally, it looks like there may be another wave of liquidity coming from central banks. Prices of financial assets typically respond before prices of goods and services. This should help prop up equities and keep yields low.