Stephen Miller
Clearly Russia/Ukraine tensions remain an intense focus for both central bankers and markets. Markets have had to contend with wild swings in investor sentiment between euphoria (witness the turnaround in equity markets on Friday night and again overnight) and despair (such as the precipitate decline in bond yields on Tuesday night).
Central bankers have had to contemplate some recalibration of finely honed messages regarding their willingness to tackle an inflation problem that has surprised with its apparent persistence.
Chair of the US Federal Reserve (the Fed), Jerome Powell, last night, perhaps understandably, exhibited some disposition toward caution in the wake of the Ukraine conflict, indicating that the Fed would “proceed carefully” in the pace of retreat from historically high levels of monetary accommodation.
He did indicate, however, that “proceeding carefully” is not the same thing as an eschewal of policy rate increases altogether. The Fed chief also gave a reasonably firm indication of a 25bp increase in the policy rate when the Fed meets on 15-16 March and remains open to a “series of rate increases” in 2022.
Powell’s relative caution contrasted somewhat with the call from Federal Reserve Bank of St. Louis President, James Bullard, who called for a “rapid withdrawal of policy accommodation.” Chicago Fed President Charles Evans described the current monetary policy stance “wrong-footed” and that it needed to be upwardly adjusted toward neutrality.
A plan to “proceed carefully” was also a theme of the Reserve Bank of Australia (RBA) Governor Philip Lowe’s statement on 1 March. Any increase in the policy rate in Australia will at the very least need to await the second half of the year. RBA Governor Lowe noted the economic uncertainties spawned by the conflict. However, like Chair Powell, he did not eschew the prospect of withdrawing stimulus altogether at some stage in 2022, directing markets’ attention to the RBA focus on ‘outcomes.’
In some sense, Australia is better equipped than other developed countries to withstand the potential fallout from the conflict. Higher commodity prices are probably a net benefit for the Australian economy. Further, being a middle-ranked power some distance from the conflict reduces negative economic ripples. A relatively benign starting point for inflation is also helpful.
While episodes of risk aversion seem more pronounced, what has been a little more surprising (at least to me) has been the extent of the decline in sovereign bond yields, given the inflation portents of the Russia / Ukraine conflict (even if it is true that ‘break-even’ inflation rates have increased in that time).
Some of that decline obviously reflects an expectation of a more cautious approach to policy tightening which may be appropriate.
But there had been a view, with which I had some sympathy, that the ‘safe harbour’ attributes of nominal sovereign bonds were questionable in an environment where inflation had been more persistent and was likely to get even more so as a consequence of the conflict.
In my mind, these considerations are still apposite. At current yields, investors are paying a lot for ‘safety’ when the same attributes could be obtained by alternatives such as inflation-linked bonds (particularly if inflation continues to surprise on the upside), gold or even exposure to a broad basket of commodities.
Is 70s style ‘stagflation’ the template?
Throughout 2021, central banks and bond markets have failed to appreciate inflation portents.
As at end-January, the gap between the US 10-year bond yield and annual core inflation – a “trailing” real 10-year yield – was, at -4.26 per cent, as low (most negative) as it had been at any time since the 1950s. As at end-February it may well be even lower, and we will know once get US February consumer price index (CPI) data next week.
The only other period in which the real 10-year yield so measured got close to these levels was around late 1974 and early 1975.
What we know about that time is that inflation expectations were way below the subsequent levels of actual inflation. This was despite a subsequent period of disappointing growth outcomes that persisted, more or less, through to the recovery in growth that emerged in early 1983.
During that period supply shocks in the form of successive oil price shocks in 1974 (after the Yom-Kippur War in 1973) and 1979 (following the Iranian Revolution) added to latent inflation in the system, culminating in the defining economic characteristic of that period: ‘stagflation’.
While not asserting that the current period is “1974 revisited”, the parallels are salutary – whether in supply blockages and surging energy prices, geopolitics, protectionist policies, enhanced regulatory agendas, or an extended period of excessively accommodative monetary policy.
Bond yields ultimately soared as central banks were ultimately forced to contain rampant inflation through aggressive monetary tightening.
‘Base effects’ on inflation are limited
In the current environment, inflation optimists assert that base effects will see a decline in the annual rate of inflation from around April this year.
However, even before the price pressures unleashed by the conflict, there were troubling indications that inflation showed no sign of deceleration. For example, the 3-month annualised rate of inflation remains uncomfortably high at 6.9 per cent in January – almost a full percentage point above the 12-month measure.
Perhaps even more worrying is that more sophisticated measures of ‘underlying’ inflation (such as the Cleveland Fed median and trimmed-mean measures) show a smooth and undiminished acceleration in such 3-month annualised measures of the ‘inflation pulse’ from as far back as late 2020. Currently these measures are above 6 per cent (closer to 7 per cent in the case of the trimmed-mean measure).
Even if inflation does recede from here, it is difficult to see it doing so at a rate which might offer adequate protection against inflation compared with alternatives.
In other words, faith in base effects may be misplaced given that more contemporaneous measures of the ‘inflation pulse’ are yet to show signs of deceleration.
Higher terminal policy rates may be the result
Clearly the current circumstance leaves central banks in somewhat of a bind.
While the Ukraine conflict would ordinarily occasion some degree of caution on the part of central banks, the issue that the bond market needs to contend with is that a more cautious approach to policy now admits the possibility of an even more intractable inflation problem.
In this circumstance, the terminal policy rate may end up higher as a result. While that remains pertinent to the US circumstance, Powell’s comments notwithstanding, nowhere is that conundrum more pronounced than in Europe where once again, the most recent inflation print surprised on the upside by a significant margin.
Euro CPI: Upside surprise again!
As if to underscore the potential stagflation conundrum facing central banks, European consumer price inflation measures again surprised on the upside. The headline CPI was at 5.8 per cent year-on-year – the highest since the inception of the Euro. Core and ‘harmonised’ core CPI inflation also exceeded expectations at 2.7 per cent and 2.9 per cent, respectively, and again underscore the challenges facing the European Central Bank’s (ECB) president Christine Lagarde.
Given its relatively acute dependence on Russia for its energy needs, the potential ‘stagflationary’ consequences of the Ukraine conflict are a particular challenge for the Eurozone and ECB.
Ordinarily, and given Lagarde’s comments after the last ECB meeting, such inflation outcomes would bring forward any ECB plan to retreat from record levels of monetary stimulus, starting with a potential acceleration of the announced tapering in the Asset Purchase Program (APP) at its next scheduled policy meeting on 10 March, and admitting the prospect of policy rate increases at some stage in 2022.
In the wake of the Ukrainian conflict that now looks problematic. Even with the announced tapering, the inflation outcomes highlight the dangers of an eschewal of a policy rate increase altogether.
As stated above, any delay to the withdrawal of stimulus in the form of a policy rate increase means that the issue the bond market now needs to contend with is the possibility of an even more intractable inflation problem. In this circumstance, the terminal policy rate may end up higher as a result. That makes a barely positive German 10-year bond yield a very expensive ‘safe harbour’ asset.
Bank of Canada increases policy rate. More to come.
In a widely anticipated move, the Bank of Canada announced a 25bp increase in its policy rate to 0.50 per cent. As with the Fed, the Bank of Canada indicated a disposition to further raise the policy rate throughout 2022.
Markets are expecting the Bank of Canada’s policy rate will hit as high as 1 per cent by June, and 1.75 per cent by this time next year. The move comes “as the economy continues to expand and inflation pressures remain elevated,” while “the Governing Council expects interest rates will need to rise further.”
With the country facing its fastest inflation in a generation, the Bank of Canada warned that price pressures are becoming more pervasive, and there are growing risks that expectations will begin to drift higher.
The bank added that it “will use its monetary policy tools to return inflation to the 2 per cent target and keep inflation expectations well-anchored.”
The Bank’s statement signalled a passive roll-off of the Bank’s balance sheet but gave no clear signal on any acceleration from that baseline but indicated that balance sheet reduction “would complement” policy rate increases.
Further announcements on balance sheet reduction – so called ‘quantitative tightening’ – are scheduled for the next meeting in April.
By Stephen Miller, Investment Strategist
