by NGOC ANH 01/10/2021, 11:10

How will central banks tighten monetary policy?

At the moment, there are many views of inflation, in which FED said that it is a little less transitory. How will central banks tighten monetary policy?

Some central banks, notably the Fed, have admitted that the rise in prices is already proving a little less transitory than originally thought. 

Nobody knows how global inflation will pan out after the Covid-related uplift that we have seen this year. What we do know is that some central banks, notably the Fed, have admitted that the rise in prices is already proving a little less transitory than originally thought. If this continues, the market will need to have faith in policymakers' claim that they have the tools to tackle inflation.

It is too early to say yet, but it seems that central bankers might have to move on from their first line of defense about rising inflation, namely that it is only temporary, to their second line of defense, which is to claim that they have the tools to tackle it. Of course, there’s really no doubt that they have the tools. They could, if they felt it necessary, not just stop asset purchases but sell bonds back to the private sector. They could also lift policy rates substantially to whatever level they deemed necessary to rid the economy of inflation. But the question is whether we can expect them to do this. There are many things that stand in the way. 

The first is that government debt is very high; inflated by the pandemic. Despite this high debt, debt servicing costs are low because yields are low. In the US, for instance, debt is around 100% of GDP but low rates mean that debt interest costs are ‘only’ around the USD300bn mark and even though the Congressional Budget Office (CBO) sees this rising to around USD800bn over the next decade it would still only be less than 2.5% of GDP, compared to around 1.5% now. That’s partly because the CBO assumes only a modest and steady rise in rates over the coming decade. If instead, rates rise much faster because of inflation, these debt costs would spiral. A 1% increase would cost well over USD200bn in extra interest expenses; so, a 5% rate would inflate the interest burden by far more than the USD1tr plan Congress has for infrastructure spending. 

Quite clearly the Fed will argue that debt costs do not enter into its thinking when it considers rate hikes, but there’s no doubt that aggressive monetary tightening with a high debt load is very different from one where the debt burden is low. And besides, even if the Fed does not take into account the impact of rate hikes on debt, it does have to factor in the effect on employment as this is the second half of its mandate. What’s more, the Fed has adjusted this mandate so that it achieves not just maximum employment but inclusive employment as well. Such a target will move further away if rates have to be hiked to cope with rising inflation, and hence investors are justified in thinking that, while the Fed might have the tools to reduce inflation, it might be reticent to use them. Another issue relates to asset prices. The Fed does not target asset prices, but it is not blind to the damage that collapsing prices can do, especially if these collapses are caused by aggressive monetary tightening. We can see from the very careful way that the Fed guides market expectations about rates that it is sensitive to both the local and international ramifications of its policy.

At the end of the day, it might be the case that the Fed only has to undertake a modest amount of tightening to achieve its 2% average inflation target. The Fed funds rate might not have to rise above the levels priced into the market or even above the Fed’s view of the ‘neutral’ rate, at 2.5%. The difficulty arises if inflation proves intractable, rendering the ‘transitory’ explanation redundant. In this case, rates may have to overshoot market forecasts and the neutral rate. Can the Fed be trusted to be this tough given some of the considerations that we have listed above? 

“We can’t be sure. But what we do sense is that central banks led the Fed, may have become inflation softies. That’s understandable given that inflation has stayed low up to recently. But now the boot might be shifting to the other foot whereby reducing inflation becomes imperative. If the market suspect that the Fed will fall short, we’re likely to see a much more significant rise in bond yields than we have seen just recently”, Mr. Steve Barrow, Head of Standard Bank G10 Strategy said.