Sentiment about Fed policy remains very volatile, but Yellen has remained remarkably stable in her outlook and bond prices have remained under control during the transition away from ultra-accommodative levels. She and the Fed deserve great credit for this, although the problems in European economies, the Ukranian situation and the resulting ECB aggressiveness clearly continued to play a role, as well. There were two dissenting FOMC voters in September, but this is somewhat normal during such transition periods and it should be noted that the FOMC roster will include more doves next year.
The taper’s completion is all but certain in October, but the “stock type” QE (the Fed’s large holdings) will remain important. We expect the phrase “considerable period” to be removed at the December or January meeting, with the first rate hike in Jun15 and 25 bps hikes per meeting thereafter. This leaves the Fed funds channel rate at 1.25-1.5% leading into 2016. While it is tempting to say the Fed should hike earlier, the strong USD and reduced commodity prices should keep inflation low and may even reduce capital spending as the US becomes a bit less competitive in international markets.
As for US inflation, the August CPI was shockingly weak, even excluding lower gasoline prices due to oil prices declining about 15% in recent months. Shelter prices are still increasing but are no longer accelerating, so core inflation will likely remained subdued, as well. In sum, we estimate that the CPI will accelerate to 2.0% YoY in March and core CPI also at that rate then, with 1.8% and 2.1%, respectively, in June, as there is a very high base year-effect. This is not a dangerous level of inflation, but coupled with the moderate decline in the unemployment rate, will justify continued Fed’s gradual removal of emergency monetary accommodation.
In Japan, the Yen’s weakness has increased the prospects of inflation, which now reduces the need for the BOJ to ease policy further (except extending the current QE program into 2015, as is widely assumed). There has been only limited criticism by the G-20 of the weaker Yen, but such could accelerate if it weakens much further, and Japan does not likely want the Yen to become too volatile. The weak macro data also caused Yen weakness, but this should reverse in the coming quarters, offsetting a part of the weakness created by diverging monetary policies with the Fed. Meanwhile, the Core CPI is losing some momentum (it only grew at 0.4% 3M SAAR in August), and although Yen weakness should help going forward, such is greatly offset by lower gasoline and utility prices ahead. Rent is a significant part of core inflation and although it has stabilized, it is not rising, without which, we believe it will be very difficult to hit the core target on a structural basis. Also, it is likely that the 2% target was made for psychological effect (to boost reflationary behaviour) and that the BOJ is secretly happy with 1.5%, which, to be honest, seems a more appropriate target to us.
The consensus (both within NIkko and in the markets) is somewhat mixed on the ECB outlook, but overall, we expect it to conduct some kind of sovereign bond QE in early 2015. It could use an indirect format/vehicle that lessens opposition to such, for instance by initially sterilizing purchases and then de-sterilizing, much as was done with the SMP. The Bundesbank is very reluctant to engage in true QE and the benefits of such are highly debateable at this stage with bond yields already exceedingly low, but Draghi seems adamant. We do suggest, however, that the QE program will be moderately sized, at least at the beginning, and if the TLTRO program (and the economy) performs much better than expected, the QE program would likely not happen at all.
As for the BoE, which is in a nearly completely opposite situation as the Eurozone, we, along with consensus, still expect it to raise rates in the 1Q15. The weakness of the currency associated with the Scottish “scare” should elevate inflation expectations and high property prices remain a “bubble” concern for a central bank with such a low policy rate.