Central bank conundrum

From

Stephen Miller

Summary

  • US April CPI: Still a high wire act for the US Federal Reserve (the Fed). A higher than expected CPI keeps maximum pressure on the Fed. Real interest rates (including the policy rate) remain low and are expected to remain so even after aggressive Fed action this year. The Fed remains engaged in that most difficult of central banking high wire acts: charting a path between getting inflation back toward target without tipping the economy into recession. The portents on that front are not good.
  • Key European Central Bank (ECB) personnel point to July policy rate lift-off. After a somewhat inconclusive Governing Council meeting on 14 April, key ECB personnel from the President Christine Lagarde (who appeared overnight to shift in her prior studied circumspection) down to Bundesbank President Joachim Nagel, and Executive Board Members Frank Elderson and François Villeroy all seem to be indicating a July lift-off for the policy (deposit) rate as it engages in the same high wire act – only their success is even more improbable.

US April CPI: Still a high wire act for the US Federal Reserve (the Fed)

A higher than expected CPI for the US reveals the stubborn nature of the inflation challenge.

Headline inflation fell from 8.5% to 8.3% while core inflation fell from 6.5% to 6.2%. Markets had thought bigger falls were on the cards with the consensus forecast sitting at 8.1% and 6.0% respectively.

The good news is that there are some indications that peak in US core inflation may be behind us. But that is about it as far as the good news is concerned.

The fall in core inflation is nowhere near enough to take the pressure off the Fed. Even the aggressive Fed that markets are currently pricing fails to get the real fed funds rate into positive territory. In other words, real policy rate yields are forecast to remain low when judged by historical standards.

On that basis it is difficult not to see an escalation of the recent hawkish communication from the Fed.

Importantly, and despite some fall overnight, the inflation outlook is not enough to take the pressure off bond yields.

Firstly, if the core number hadn’t shown signs of rolling over then the inflation challenge was even more dire than thought.

Finally, there is the current gap between bond yields and core inflation.

As at end-April, the gap between the US 10-year bond yield and annual core inflation – the “trailing” real 10-year yield – was, at around minus 3.2%, still very low by historical standards.

Apart from the recent post-pandemic period, and perhaps fleetingly in 1980, the “trailing” real yield is at levels that were last seen in the mid-1970s.

To put that in some context, in the three years leading up to the onset of the pandemic US 10-year real “trailing” yields averaged around 0.40 per cent (still very low in historical terms).

There are a few ways that the current gap between core inflation and the US 10-year bond yield might close and come close to that level.

A benign view is that inflation is essentially transitory, if elevated for longer than originally thought. Partly reflecting much tighter monetary policy, core inflation will return to the mid to high 2’s within the next year or two. Accordingly, 10-year bond yields settle in the around the low 3s and the gap between nominal yields and the “trailing” real yield reverts to something close to the 2017-2019 average.

A less benign, and arguably more realistic scenario is that the inflation is more intractable.

In 2021 a complacent Fed let inflationary expectations escape the realm of being within their ability to comfortably manage.

Inflation expectations have a habit of being self-fulfilling through their effect on wage and price setting behaviour.

Accordingly, even if inflation does recede from here, it might not do so as far, nor as fast, as the Fed and markets currently assume.

Inflation is “sticky” at around the low to mid 3s. Such a scenario reflects a “1970s-lite” outcome.  A return to the 2017-19 average “trailing” real yield implies a 10-year yield reaching the mid to high 3s and more in the next year or so.

There are troubling indications that inflation may well be “sticky”.

Sophisticated measures of ‘underlying’ inflation (such as the Cleveland Fed median and trimmed-mean measures) show stubbornly elevated inflation. Such 3-month annualised measures of the ‘inflation pulse’ are well above 6%.

Despite an apparent peak in core inflation therefore, a demonstrated Fed complacence about the magnitude and momentum in inflation through 2021 means that the engineering of a “first-best” solution is now be beyond the Fed.

The Fed remains engaged in the most delicate of central bank high-wire acts: charting a path between getting inflation back toward target without tipping the economy into recession.

Of course, a fortuitous mix of productivity gains, unblocked supply chains, increasing labour force participation, financial market resilience and the deft execution of the high-wire act by the central bank could see the US economy navigate the challenge ahead.

Unfortunately, history is replete with failed central bank attempts at such a high-wire act, particularly when faced with high and persistent inflation. The problem is compounded when it starts from a long way back coming off a period of historically high levels of monetary stimulus, and where “aggressive” counts as getting the real policy rate back close to zero.

The forgoing suggests that despite a more aggressive approach from the Fed, financial markets may well remain in a volatile phase as they take time to assess the success of the Fed in reining in inflation without risking a substantial economic dislocation. The assessments arising from the Ukraine conflict (which also looks to be with us for an extended period) together with the fallout from China’s COVID lockdown only add to the sources of volatility.

Key ECB Personnel point to July lift-off for the policy rate

Meanwhile, ECB President Christine Lagarde gave perhaps the strongest hint yet that at its next meeting on 9 June, the ECB will formally announce the end of the ECB QE program after the completion of those asset purchases already scheduled for June. Moreover, comments from Lagarde and from Bundesbank President Nagel and Executive Members Elderson and Villeroy, point to a strong likelihood of a follow-up policy rate increase on 21 July.

Lagarde’s comments represent a slight shift from the studied circumspection of her recent communication.

That circumspection took the form of pointing to differences between the inflation circumstances confronting the US and those in Europe with Lagarde asserting that he ECB was “facing a very different beast” to the Fed, given that higher energy prices account for half of eurozone inflation and that if the ECB were to “raise interest rates today, it is not going to bring the price of energy down.” Lagarde also has referenced the fact that  the war in Ukraine will hit Europe’s economy harder than most regions.

It is also an inconvenient truth that the ECB is cursed with an institutional inertia in its decision-making processes. The ECB President is, however, too much of a diplomat to canvass such an issue in the public arena.

Nevertheless, her overnight comments were taken as a tacit acknowledgement that July 21 is the likely lift-off date for an ECB increase in the policy rate. With Lagarde saying that the first interest-rate increase in more than a decade may follow “weeks” after the end of net bond-buying early next quarter, joining a growing crowd of policy makers signalling a move at the July 21 meeting. In doing so she seems to have acquiesced to the more hawkish wing of the Governing Council. This includes Bundesbank President Nagel who pointed to “disturbing evidence that the increase in inflation is gaining momentum”. More consumers and companies expect prices to keep rising rapidly, which meant “the risk of acting too late is increasing notably.”

As mentioned above in the case of the Fed, inflation expectations have a habit of being self-fulfilling through their effect on wage and price setting behaviour. It is this process rather than the ability of the ECB “to bring the price of energy down” that is exercising the hawks.

Faced with record inflation that at 7.5% is almost four times the ECB’s 2% goal the hawks have favoured a hike at the July 21 meeting.

Money markets are fully pricing quarter-point increases from the ECB in its July and September decisions, with a further hike by year-end.

Those moves emphasise the relative caution from the ECB compared with the Fed.

The ECB (like the Fed) is also engaged in that most delicate of central bank high-wire acts: charting a path between getting inflation back toward target and without tipping the economy into recession.

In the case of the Fed, the point was made that history is replete with failed central bank attempts at such a high-wire act.

For Europe the probability of a fortuitous mix of productivity gains, unblocked supply chains, increasing labour force participation, financial market resilience and the deft execution of the high-wire act by the central bank seems even less likely.

By Stephen Miller, investment strategist 

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