Ideally, a rise in the price of oil, resulting from improvement in worldwide economic conditions, would increase inflation expectations and also pull up long-term interest rates. This could steepen the yield curve, or at least displace it upwards. All other things being equal, bank shares would benefit and their poor performance of the last few weeks would turn around. Even though higher interest rates would penalize a certain number of sensitive sectors, the breath of fresh air for the banking sector would restore some appetite for risk which has recently been lacking.
More realistically, i.e. with an economy well into the expansion phase, there is little chance this series of events would last. It is not even sure they would have the time to develop in the first place, despite some indications to the contrary over the past few days.
Our activity indicator was stable at 0.1 in January, held back by a slight weakening in consumer spending. Investment remained buoyant and exports were still positive despite varying trends between regions. Our inflation indicator moved further into positive territory, to +1 from +0.5 in December.
Trends in the financial markets have accelerated in the last few days. After hesitating slightly at the start of 2018, it is increasingly obvious to investors that reflation is around the corner. That belief is based on widespread growth, a surging oil price, the first positive effects of Donald Trump’s tax reform – with giant US companies promising to repatriate profits – and good news on investment and jobs. It is hard to see how that situation could fail to end the phase of latent deflation in the last few years and support expectations – seen throughout 2017 – of inflation getting back to normal. The impact of rising oil prices alone could significantly change the inflation situation, judging by how sensitive inflation is to movements in oil prices. If crude stabilises at $70 per barrel between now and the summer, inflation could rise by more than half a point in the industrialised world, taking it well above the 2% target that it touched only briefly in February 2017.
So what could prevent a significant increase in interest rates? It is very tempting to change our outlook for 2018. How is the interest-rate environment likely to develop?
Is the Bank of Japan about to embrace tapering? The idea suddenly came into renewed focus at the beginning of the week when the BoJ reduced its purchases of long-term securities as part of its usual quantitative easing operations. The market responded without delay: the price of Japanese government bonds immediately declined, but more importantly, the yen rose against most other major currencies. It is understandable that the markets would anticipate such a change. The BoJ’s increasingly large recovery operations have been underway for many years and have inflated its balance sheet to 92% of Japan’s GDP, while the Fed and the ECB have both committed to gradually reducing their monetary policy support. What’s more, the Japanese economy seems to have found new vigor in the last year. That said, it is unlikely that the Bank of Japan has the latitude to begin reducing its monetary support. There are at least three reasons for this.