Central banks on defensive over inflation

Mizuho with the note:

Central banks are often viewed as the guardians of inflation, but the Fed and ECB now face a predicament: with rapidly rising prices a political issue in the US and elsewhere, central banks that remain dovish have come under increased criticism and been forced to reframe some of their commentary.

Rate hikes are fundamentally ineffective when inflation is the result of supply-side constraints, as numerous central bankers have been reminding us. Rate increases designed primarily to head off an upward shift in inflation expectations can backfire: it is impossible to manage the markets with precision, meaning market rates (and exchange rates) can rise too far and damage the economy.

However, a central bank can become consumed by the feeling that it has to do something to break the cycle of the bond market pricing in an early rate rise and both politicians and a variety of experts (including former colleagues) climbing on board the narrative that it is behind the curve.

The “something” is to shift to a more hawkish approach to monetary policy. With supply constraints likely to remain until Jan–Mar 2022 and the YoY rate of increase in the CPI continuing to accelerate, it appears that the predominantly dovish Fed and ECB are being forced to retreat to an even deeper defensive line.

At the Fed, which began its QE taper in mid-November, the most likely option is to bring forward the end of the taper from the currently anticipated date of June 2022. A number of regional Fed Bank presidents have already begun to provide commentary suggesting this: please see our 24 November Macro Information Markets fluctuate on mixed news, including
talk of earlier policy normalization in the US and fears of a new COVID-19 wave. However, the big problems lie further ahead.

Jay Powell will probably have to admit publicly that the first rate hike is now more likely to occur sometime during 2022. However, the markets have already priced in an initial increase in June and two more during the second half of the year. We suspect Mr. Powell will follow the lead of Bank of England Governor Andrew Bailey by warning the markets that they have gone too far.

This all underlines the need for policymakers to think carefully about their messaging to the markets, while remembering that being too vague can lead to market instability. It is entirely possible that the more hawkish tone from FOMC members other than the chair, and missteps by the chair himself, could cause yield curves to flatten further. This could happen if Treasury yields to rise further in the middle of the curve (5y) and central bankers dissuade investors from their cross-border hunt for yield among long-term and superlong bonds. The markets may then start to fret about an approaching yield inversion, traditionally a recessionary signal.

In the eurozone, where government bond yields tend to move in line with the US Treasury market, our sense is that ECB officials are becoming somewhat less dovish in their remarks. Board member Isabel Schnabel prompted speculation about a rate hike in 2022 when she said in an interview with Bloomberg on the 23rd that inflation could remain above the Bank’s target in the medium term. While we doubt the dove-dominated ECB has any intention — at least for the present time — to raise rates earlier than expected, we do think more officials will rule out the need for transitional measures (such as to avert an asset purchase cliff) to help smooth the end of QE on 31 March.

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