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Yesterday’s expectations of a rate rise from the Bank of England passed with a whimper as they voted unanimously 7-2 in favour of a rate hold – for now. The ball is firmly in the court of the central banks as to how they deal with inflation and in the UK the effects of the end of Furlough need to be examined first. Our key focus remains on how central banks engage with and convince market participants of an appropriate path for policy rates in the next couple of years.
Evidence increasingly suggests that post-pandemic rise in inflation risks will be longer term and more pervasive than thought a few months ago. Since early September, market pricing of where short-term rates will be in 18-months’ time (a window of time typically covered by central bankers’ attempts at forward guidance) has risen sharply across a range of markets. Bond yields have broken above their immediate pre-pandemic levels and rate expectations in Europe and the UK are suggesting the pandemic-era monetary policy settings will be fully reversed by early 2023.
The risk here is that markets take interest rate expectations higher. Inflation expectations have become un-anchored. Market participants do not have much collective memory of central bank reactions to higher inflation because they have been conditioned by low and sticky inflation for many years. Now the inflation cat is creeping out of the bag, the incumbent framework for setting rate expectations is perhaps inadequate. It is noteworthy that attempts by central bankers to reverse market expectations have been absent or ineffective in recent weeks. It is almost as if central banks want the market to do their work for them. The US Federal Reserve (Fed) have now started the tapering of asset purchases. The European Central Bank is struggling to convince the market that it is wrong on rate expectations and to articulate what will happen to asset purchases next year.
High inflation and higher than expected rates are an important threat to growth expectations. A rate shock and an energy shock will hit household incomes. This poses a risk to the outlook over the next 1-2 years. So far, risk markets have not got the growth scare. Perhaps credit and equity markets reflect the view that all we are seeing is a long-awaited return to monetary conditions as they were in 2019 before anyone had heard of COVID-19. Real interest rates are negative and if lots of economic agents are benefitting from higher nominal growth (wages) then the rise in the cost-of-living might not be so damaging.
There is also the possibility that the central bankers are right on inflation being longer term, although we must remember that the very high rates that have printed in recent months are more related to base effects and COVID-19 related supply. Even the shocking 1.3% increase in the US employment cost index could be partly related to the end of furlough and emergency unemployment benefits and companies paying up to entice workers back into employment. That is not necessarily a permanent state.
The rate shock requires central banks to respond. They did a great job in keeping market expectations stable throughout the pandemic. Exiting the pandemic was always going to be tricky but the expansion is at risk if markets push rates up more. Monetary policy cannot do anything about oil prices other than force a collapse in demand and I am sure that is not on anyone’s agenda. But what they can do is send a message saying rates do need to rise but in a controlled way and not as aggressively as some market pricing suggests. It was therefore interesting to see the Bank of England keep its powder dry yesterday. If Central Banks can manage market expectations once more, the risk of a market fall in bonds and equities is greatly reduced.