Central banks to fight the “new” war

U.S CPI inflation currently stands at 5.3% compared to 3.2% in the UK.

A number of key central banks, not least the Fed and ECB have changed their monetary policy strategies in the past fourteen months. They changed policy to fight the pre-Covid deflation and zero lower bound war that has been raging since the global financial crisis. But this seems to be an ‘old’ war and it is not clear that these new policies are suited to fighting the ‘new’ war, which is against inflation, not deflation.

When countries are hit by a shock, like the global financial crisis, they put in place measures to mitigate its effects and try to ensure that it cannot happen again. The first task of policymakers was clearly to work on improving bank capital and bolstering this in the years since the global finance crisis has meant that the next shock – the pandemic – has not morphed into a financial crisis.

A second task, which came about more recently, was to fight some of the consequences of the post- global financial crisis period, such as lowflation and even deflation, as well as coping with the constraint of the zero lower bound for rates. The Fed and ECB were two banks that made changes to their monetary policy strategies, both of which, in their own ways, were designed to encourage higher inflation than before in the hope that this might prevent the zero lower bound problem becoming a semi-permanent constraint.

However, just like a sailor caught out by a dramatic change in the weather, and is not prepared, these central banks must be wondering whether their new strategies are fit for purpose given the inflationary storm clouds that have gathered overhead. If central banks are wondering this you can be sure that investors are too. Of course, not all central banks have changed their monetary policy strategies in a similarly dovish way to the Fed and ECB. The Bank of England and Bank of Japan have made no such moves and these provide us with a sort of placebo against which we can measure the extent to which the market might think that these new monetary strategies have raised inflation expectations.

Of course, inflation expectations have gone up in the US, but only in line with those in the UK; there’s been no ‘extra’ uplift from the Fed’s new monetary strategy that is more accepting of inflation overshoots. Should we be surprised by this? Not really. Investors are probably stuck with the old psyche that central banks still see high inflation as bad despite what they might say. Hence the market is probably still reticent to believe that the likes of the Fed and ECB will pursue policies that are notably more dovish than in the past. We can see this in the way that breakevens in the UK, for instance, have risen in a similar fashion to those in the US even though there’s been no dovish alteration in the Bank of England’s monetary strategy. What’s more, we’ve also seen US inflation rise much more than in the UK as it currently stands at 5.3% on the CPI measure compared to 3.2% in the UK.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, admitted that market-based measures of inflation expectations like breakevens or inflation swaps would be not perfect examples of price formation. In the UK, there’s a very strong institutional demand for index linked gilts that arguably distorts the resultant price information while, in the US, we know that periods of tensions, when treasuries become heavily demand, such as during the height of the pandemic, can distort market-based inflation measures. But, for all these defects we’d still stick by the idea that the central banks that have undertaken these dovish shifts have not yet been ‘rewarded’ by a notable upshift in inflation expectations as a result of the change. That might be one reason why their currencies have been reasonably solid. In time though, more a significant uplift could still come through, especially if inflation stays elevated, and that could have adverse consequences for the euro and the dollar, as well as the bond markets.