The generally optimistic tone at Davos last week was rudely interrupted by a melt-down in emerging markets, triggered by concerns that the major central banks in the developed economies are contemplating an exit from easy money sooner than previously expected.
The Fed will probably take its second step towards tapering next Wednesday and now seems to be on auto-pilot for the rest of the year. More surprisingly, the Bank of Japan sounded some cautious notes about the likelihood of further quantitative easing when fiscal policy tightens in April. Finally, the UK authorities, in the shape of “aides of the Chancellor”, hinted that a rise in short rates may be no bad thing this year.
A significant shift towards tighter monetary policy in the developed world as a whole still seems extremely unlikely, given the deflation risks highlighted by the IMF last week.
But the British case is now very intriguing and, after contradictory messages at Davos, also somewhat confused.
Because of low productivity, the level of UK GDP continues to lag well behind the recovery from the Great Recession achieved in many other economies. But the remarkable recent surge in UK growth rates, along with a sharp fall in unemployment, means that the Bank of England now has to reconsider its entire monetary stance. With forward guidance now in murky waters, the markets will want greater clarity in the next Inflation Report in February. Read more