Many central banks: Reactive, not proactive

Back in the summer of 2020 the Federal Reserve changed its monetary policy strategy somewhat. The most notable change was to target “inflation that averages 2% over time” rather than a simple 2% inflation rate. But other more subtle changes have occurred. One is that the Fed, and perhaps many other central banks have well, have taken a bit more of what we would call a ‘whites of inflation’s eyes’ approach to policy.

What we mean by this is that policymakers are basing their actions less on their forecasts for the future and more on their assessment of what is happening now. In other words, they don’t act until they see the whites of inflation’s eyes. Past forecasting failures and significant improvements in the collection of higher-frequency data are just two of the reasons why we sense that policymakers have made this change. It might only be a subtle change but it is important in our view.

One reason why many people think it is important is that it encourages the private sector to make its financial market decision-making in the same way. The most obvious example of this is how the market seems to hang on data releases, like the monthly CPI data or payroll numbers more so than in the past. Now clearly part of this is down to the fact that we have moved into a more dynamic part of the policy cycle.

In other words, official rates are starting to move and central banks are more data dependent, as opposed to those periods when rates are static and unlikely to move. But even allowing for this our sense is that traders and investors are relying more on the ebb and flow of data, and other events, to shape their activity, and less on proactive positioning. Why is this? One reason could be that, just like central banks, investors have better access to high-frequency data or news sources that permits a more reactive mindset. Another is that traders and investors likely choose to use other instruments, like options, to take more proactive positions than spot markets.

For instance, if we look at the US election, there’s little evidence that spot FX markets are priced to cover the possibility that former president Trump could win a second term. Instead, we see this in the options market where a notable gap has opened up between actual volatility and implied volatility. For instance, if we look at 1-month historical and implied euro/dollar volatility we see that implied vol has surged to around 7.5% even though actual volatility has risen relatively little and sits some way below implieds.

Another example is the oil market. For even though spot prices have moved up a bit, it does not seem as if the market is being proactive and really covering the very-real possibility that tensions in the Middle East bubble over to compromise oil supply. It is only in the options market where the rise in volatility seems to cover this scenario to some extent.

Once again, some would say that this is how it always is in the financial markets as investors always want to wait for events to unfold, and then to react, rather than take a speculative guess ahead of time. Steve Barrow, Head of Standard Bank G10 Strategy doesn’t disagree with this, but he would still argue that the amount of proactivity is relatively low right now. This could be a reflection of central bank policy as discussed earlier.

In fact, central bank policy may be working in another way as well because past central bank recourse to throwing large amounts of liquidity at the financial sector when adversity strikes may mean that the impact of adverse shocks on asset prices are deadened. For instance, think about how stocks rebounded after the Covid-related slump in 2020. This, in turn, suggests that proactive positioning may yield little benefit. Does this mean that traders and investors should shy away from trying to anticipate the future and, instead, just rely on responding to the present? Steve Barrow said it would be probable.