Market Monetary Policy Jitters Nick Keeling

There’s no doubt about it, there’s a jittery mood in financial markets, causing flip flopping behaviour in equities, bonds, commodities and even Bitcoin. Like most periods of intense volatility, uncertainty is the cause. Given the unprecedented economic impact of the pandemic, no-one really knows how this will play out and what the policy response will need to be.

The near-term data will undoubtedly be strong, compared as it is against the pandemic collapse of a year or so ago. Added to this, supply bottlenecks and other issues are adding to pricing pressures for companies; lumber prices in the US are a great example, where the lumber industry has been caught out by strong housing demand driven partly by changes in behaviour. Growth and inflation data will no doubt jump over the coming months.

But the question is: how strong for how long?  And it’s this question that has investors concerned. In the US, inflation fears have driven up bond yields and caused a number of mini equity crashes, despite, and sometimes driven by, Federal Reserve policymakers reiterating that inflation is likely to be transitory and noting the need to look through this period to set the appropriate policy. There are clear pressures growing in the US, however, and with the US government attempting to push through multiple stimulus packages, it’s easy to see why investors are concerned. Will the FOMC act sooner rather than later? Or will they act too late, leading to a more aggressive response?

It’s fair to say that inflationary pressures appear less robust in the UK, where the strengthening of sterling has helped dampen some of the dollar-denominated commodity price pressure. However, input prices are on a sharp upward trajectory and output prices a slightly shallower one, preceding a rise in the CPI rate to, and possibly above, the 2% target. MPC policymakers also expect the inflation spike to be temporary, reiterated most recently by external member Gertjan Vlieghe. He made some interesting points in a speech last week, that chime with the apparent desire of central banks to act after stronger inflation is evident, rather than acting in the traditional manner ahead of the perceived inflationary threat:

1) tightening monetary policy too early is worse than too late;

2) inflation reacts quickly to monetary tightening;

3) the necessary monetary tightening to bring inflation back to target will be relatively small.

The second point is interesting because received wisdom is that changes in interest rates have a lead time before the full impact is felt by the economy. If inflation is actually more responsive to changes in interest rates, then waiting until inflation is at higher levels before reacting will not necessarily risk higher inflation expectations becoming embedded. Vlieghe puts this down to entrenched inflation expectations driven by a known central bank intolerance of persistent deviations from target. His message appeared to be that inflation/policy concerns are misplaced – monetary policy needs to be looser to boost inflation and growth in the medium term, the MPC can act swiftly when necessary to bring inflation back to target, and they do not actually have to raise Bank Rate significantly to do this.

Of course, Vlieghe is only one of nine MPC members and was keen to point out these are his own views, not those of the Committee (which he is leaving in August 2021). But if he’s right, what does that mean for markets? Well, it might be that markets are on the same wavelength, for all the volatility. Equity markets appear to be priced on persistently loose monetary policy, while gilt yields have risen but mainly on inflation expectations rather than rate expectations, and remain very low despite that. It seems that, as Vlieghe perhaps inferred, low interest rates beget low interest rates.

However, Vlieghe was also much more forthcoming on his views of the potential path of Bank Rate compared to many of his colleagues, suggesting Bank Rate at 0.5% mid-2023 and 0.75% mid-2024, which are fairly close to market expectations although above our own. But these do underline the main message, that any increase in rates is likely to be in small increments over a prolonged period. During the period after the GFC, we envisaged Bank Rate topping out at 3% or so, below the previous 4-6% range. Wherever the new range is, it’s certainly much, much lower than that.

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