FILE PHOTO: The Federal Reserve building is set against a blue sky in Washington, U.S., May 1, 2020. REUTERS/Kevin Lamarque/File Photo
March 24, 2021
By Mike Dolan
LONDON (Reuters) – This time it is probably different – or at least for monetary policymakers and markets trying to track them.
Fuzzier Federal Reserve targets are creating a fog for other central banks and for investors gauging the next upswing in the interest rate cycle over the coming years.
The new average inflation regime hasn’t been tried before and only the Fed has formally adopted it so far – leaving considerable uncertainty over how the Fed itself will behave, and also over how other countries react to a new mandate in Washington while they still observe the old ones.
Desired or not, the dollar’s still-dominant role in world finance means the Fed’s trajectory remains as critical as ever for countries’ financial policy and planning – especially in emerging markets, but in developed economies too.
Last year’s strategic review of its inflation goals gave the Fed substantial room for manoeuvre over when exactly to act on rising inflation.
As it’s no longer strictly bound to tighten credit when inflation is set to exceed the 2% target, due to a new long-term averaging of that goal, it can – and plans to – run the economy ‘hot’ as long as it deems the coming inflation spike temporary.
It stressed that again over the past week – saying the majority of its policymakers still saw no rate tightening before 2024 – and indicated it would not change its stance without clear evidence of a shift in long-term inflation or employment developments rather than the mere forecasts of such.
GRAPHIC: The Fed keys on inflation expectations – https://graphics.reuters.com/USA-FED/INFLATION/bdwvkmkodvm/chart.png
All that may make sense for today’s America – but it’s still from far clear how it plays out for the rest of the world.
When it was rolled out last year in the middle of the pandemic, many assumed the change would simply lead to easier money for longer and a weaker dollar to match.
That has its own overseas strains – but arguably more easily managed by emerging market central banks that can lean against exchange rate strength, build hard cash reserves and keep finance stable.
But the initial thinking didn’t quite capture the scale of the subsequent U.S. fiscal boost and the resulting rise in real bond yields this year that has confounded consensus and strengthened the dollar steadily.
This seriously complicates the U.S. view, first and foremost.
Not having played this particular game before, financial markets have in effect been left to make up their own minds. And their assessment to date, correct or not, is that the Fed will blink earlier and raise rates as soon as next year – sending real-inflation adjusted bond yields climbing as a result.
Siding with the hawkish fringe of the Fed council, futures pricing appears to see such loose fiscal policy leading to rapid growth, re-employment and inflation that allow the Fed to start ‘normalising’ much sooner than it’s currently indicating.
“It’s an outcome-based test,” claimed Dallas Fed chief Robert Kaplan on Tuesday, adding he was one of the policymakers expecting a rate rise next year.
But that foggy view makes a mess of the outlook for central banks adjusting to the inevitable overspill of U.S. conditions – with a sudden, dramatic reversal of investor flows to emerging markets this month triggered by a spike in Treasury yields.
Within a week of those outflows, Brazil, Russia and Turkish central banks rushed to jack up interest rates in the throes of a pandemic in order to head off currency weakness – with the scale of Turkey’s tightening enough to see its central bank boss ousted at the weekend and the lira in tailspin again anyhow.
GRAPHIC: Emerging Market currencies through the pandemic – https://fingfx.thomsonreuters.com/gfx/mkt/qzjpqlozmvx/EMFX.PNG
“Investors didn’t give up their bullish emerging market view until U.S. (10-year) Treasuries hit 1.6%,” Morgan Stanley’s EM team observed. “But the spike in USTs was a wake-up call to everyone and investors have become more cautious on EM since.”
But this second-guessing of the gradual evolution in Fed thinking is not solely an emerging market problem.
The spike in U.S. real yields spilled over to Europe too, where a third wave of the pandemic is still in full swing and lockdowns still tightening. And this already forced the European Central Bank to step up its bond buying programme – less sure that euro zone fiscal spending will come close to Washington’s.
But at least the ECB already looks set fair to follow the Fed’s strategy rethink toward more flexible inflation targets.
The Bank of England is still theoretically bound by its government-mandated 2% point target for inflation and its chief economist and others are already chomping at the hawkish bit.
Despite a dire year for the British economy and the trade sensitivity of any outsize sterling strength, futures markets see the BoE lifting rates before the Fed – partly because of its now stricter mandate during a reflationary period.
GRAPHIC: G4 Policy Interest Rates – https://fingfx.thomsonreuters.com/gfx/mkt/nmopardarva/G4.PNG
“There is a genuine worry around persistent excess inflation for some in the internal camp within the (BoE) and we think this will continue to play out over the next several months, especially given the Bank’s symmetric inflation target,” Deutsche Bank economist Sanjay Raja said.
Offsetting factors include tighter UK fiscal projections that may allow the BoE to hang loose for longer, Raja said.
“The bar for the BoE to tighten policy over the next two to three years may be high, though not entirely insurmountable.”
GRAPHIC: Emerging Market CDS rates over 12 years – https://fingfx.thomsonreuters.com/gfx/mkt/bdwvkmlbqvm/EMCDS.PNG
(The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own)
(by Mike Dolan, Twitter: @reutersMikeD; editing by John Stonestreet)