How do central banks respond to inflation?

The Fed has a new monetary policy strategy that it adopted last year which encourages an overshoot of inflation when price trends in recent years have generally been below target.

If banks hike too quickly and aggressively it risks capitulation in asset markets, with all that this could imply for economic growth and debt dynamics. If they prove too dovish, inflation expectations will take hold, possibly forcing an even bigger policy tightening in the future, leading to the same implosion of risk assets. In other words, central banks, particularly the Fed, are walking a tightrope at the moment and investors will just have to hope that they can stay on.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy said: “Our view has long been that inflation is likely to prove a bigger problem for central banks than they anticipate and we still hold to this view even though some central banks seem to have woken up to the risks. But rather than assume that this will shift the Fed into a much more hawkish frame of mind, we’ve erred to the view that the Bank will continue to be patient; perhaps too patient. We still take the same view even though it seems that the Fed is on the verge of making its first significant monetary policy move via the tapering of its asset purchases”.

Why is the Fed likely to stay patient? For one thing, the Fed has a new monetary policy strategy that it adopted last year which encourages an overshoot of inflation when price trends in recent years have generally been below target. Of course, the Fed has not been explicit about just how much overshoot it wants and for how long, but the point is that the Fed’s reaction function is still different today than it was before August last year when the new strategy was adopted. A second factor is that the Fed is likely to retain faith in its view that inflation is temporary, just as it has been doing despite the high numbers that have been coming through. A third factor relates to the balance of risks both for the domestic economy and the rest of the world.

In short, does the Fed believe that it is better to accept a point or two of higher inflation if this allows the recovery to proceed, rather than risk cutting the recovery – and financial markets – stone dead by hiking rates sharply and with relatively little warning? “We dare say that some on the FOMC might be prepared to countenance the latter if it means that inflation is nipped in the bud, but we don’t think that this will be the majority view, at least not for some considerable time”, Mr. Steve Barrow said.

If this interpretation is correct the key then becomes the degree of tolerance the market shows for the Fed’s strategy. At the moment, the market is pricing in two rate hikes from the Fed by the end of next year while the most recent DOTS plot from FOMC members saw a split between those anticipating one rate hike next year and those assuming no hikes at all. In short, the market is clearly ahead of the Fed.

We’ve seen marketbased inflation measures like breakeven rates and forward-starting inflation swaps moving up quite briskly, which suggests that the market might be losing a bit of patience with the ‘transitory’ inflation story espoused by the Fed. However, our sense is not that market pricing is putting undue pressure on the Fed to come out with a more hawkish slant on its future policy intentions. For while we suspect that the next DOTS plot from the Fed probably will be a bit more hawkish than the current one, we suspect that most members will still be wary of being bounced into an early and/or more aggressive tightening of policy by the market. In our view that’s likely to be positive for risk assets, but not for the dollar and not for the longer end of the treasury market. But those that are short of the dollar and longer-dated treasuries will clearly have to hope that the Fed does not do a major about-turn somewhere down the line and start to lift rates far more aggressively than current market pricing. That’s always possible while inflation data continue to overshoot but, for now at least, we’d still err towards positions that are short of the dollar and short of treasuries, said Mr. Steve Barrow.