Central banks have a host of problems on their hands. And the only two things that are firmly under their control (by and large) are interest rates and fiat currency liquidity. What they wish they had control of is expectations because that is likely to be volatile for a while yet.
Under normal circumstances the band of possible outcomes is usually quite narrow and many events are forecastable. Under these current strange circumstances it’s hard to tell whether all will be back to normal by the end of August or we’ll be in another lockdown of some sort in December. The Delta variant of the Covid mutation and the new mutant Delta+ variant has thrown a spanner in the works of many ‘return to normalcy’ timetables and further waves are expected in the coming months.
What was feared last year: K-shaped two track recoveries, is now almost a certainty. Some countries are going to fare far better than others- depending upon the determination displayed in getting on top of the virus epidemic. Thus, different countries have different time-frames for the duration of the stimulus packages which they have all put in place. The resurgence of inflation- metals, food and energy mainly, is threatening to upset the carefully balanced act of high liquidity/ low rates that the central banks have been pursuing. And the entire financial world has been collecting pennies in front of the steamroller: borrowing ultra-cheap money to place on risky bets. Over time the market has become highly leveraged, chasing after ever decreasing returns on assets that are richly priced, on the knowledge that a slight change in the wind will send those assets tumbling in value. Over the years the assurance that central banks would always be there to prevent such an eventuality became known as the Greenspan Put, then the Bernanke Put. Is Powell going to take over the mantle or will these be the years of reckoning?
Central bankers have their own agenda. They are less concerned about the equity markets and more about the restarting of the real economy with as little pain to the common man as possible. Powell has enlarged the remit of his job to ensure that conditions remain right for joblessness to fall as much as it is for them to ensure that inflation is controlled. Monetarism is taking a bit of a back seat. This is what they need to convince markets of: that economic growth and low unemployment is better for valuations than cheap funding but that they will keep that cheap funding going in order to achieve those two objectives.
What this means for central bankers- especially in this day and age of market participants reading the tea-leaves of every statement, is that they have to manage and even- to an extent, change perceptions. The first is simple in that it is part of what’s been expected of them as their central role: manage expectations about inflation. And prices have increased thanks to all the fiscal support made available to support stalled economies. The resurgence in demand coupled with the logistical bottlenecks and reduced production schedules that have built up is causing short term price surges. And Powell has been careful to note the short term nature of those rises.
As shown in an earlier article, the inflation bogey is likely to be short-term in nature and mainly in areas which will not affect broader growth parameters. Powell said inflation had picked up but should move back toward the U.S. central bank’s 2% target once supply imbalances resolve. Currently CPI in the G20 is running at 3.8% (April data), while the reference rate for central bankers is 2% for price stability.
“Inflation has increased notably in recent months,” Powell said in written remarks prepared for his Tuesday testimony before the House Select Subcommittee on the Coronavirus Crisis, citing increases in oil prices and a “rebound” in spending as the U.S. economy reopens. But… ”as these transitory supply effects abate, inflation is expected to drop back toward our longer-run goal,” he said.
But this is the expectations management part of the exercise. They need to convince the market that their policies are still the most appropriate at the moment despite this temporary inflation spike. By convincing the market of that there would be less disruption in their attempt to coax the right animal spirits back to create the job based growth they are all looking for. The market is looking at something else: they are focused on the self-confessed likelihood that the Fed will start to raise rates in 2023. In fact, in the Fed June meeting- of the 18 voting officials, 11 saw the likelihood of 2 rate hikes in 2023 and 7 even saw the possibility of a rate hike in 2022. This is causing the market to break out in spasmodic bouts of self-doubt.
Whilst some other central banks are already looking at exit strategies for their stimulus programmes- like Canada and Norway for example, the Bank of Japan is concerned that some countries, still not recovered from their fight against the pandemic, will be forced to raise rates prematurely in order to defend their currencies. But, whichever side they’re on they are susceptible to the tremors of international capital coursing through their economies as they shiver and shake every time the Federal Reserve has to explain its thought process and likely course of action. And markets seem to be either in a state of euphoria or panic. So, the central banks now need to reassure the markets that- though inflation may be running hot at the moment it is a temporary phenomenon. And- probably more importantly, that central banks are comfortable with inflation rates running above their comfort levels until there are clear indications that the economy is humming along nicely and that joblessness has come down to pre-pandemic levels. This is the critical argument they need to convince the markets of- not because the markets need to be enlisted in the struggle to get the economy back on track but because the financial markets- leveraged up to their nostrils, can ruin the whole show by panicking. In other words, they need to change the market perception of the primary goal of their policy objectives.
The problem these days, of course, is that, with nearly twenty years of low interest rates and high liquidity, more and more money has been created and pulled into the high stakes casino of markets. There have been unspoken assurances that catastrophic falls will be addressed with accommodative policies. These low cost money junkies are the ones whose expectations will have to be met. It’s no longer main street that needs to be addressed but the cowboys of finance. The difficulty is that many will soon come around to the realisation that the downcycle of rates is over and- barring another catastrophic event, the only way is up eventually. And they aren’t used to that.