Credibility is everything in financial markets, especially for central banks. After a number of central bank meetings last week, their credibility is increasingly under the spotlight.
As many of you will know, central banks have spectacularly underestimated the level and persistency of inflation over recent times. For example, the Bank of England (BoE), in May last year argued that inflation was “transitory” and that it would be 2.5% by the end of 2021, before returning near to the 2% target. Now they think inflation will be 11% before year end: a dramatic turnaround.
Very much related to this, forward guidance has also been poor, even across very short term horizons. For example, at their May meeting this year, the US Federal Reserve (Fed) ruled out a 75bps hike at their June meeting, only to end up raising rates by 75bps.
We have long doubted the accuracy and usefulness of trying to forecast, and we include ourselves in this, not just central banks. What was perhaps more disappointing than their self-confidence in forecasting, was the dogmatism they exhibited when faced with the facts. These repeated mistakes have damaged their credibility, or the degree to which they are trusted, but this isn’t limited to the US and UK central banks.
Indeed, it’s very fashionable to lambast central banks but we also need to recognise that it is a tricky environment. First there is inflation, which is flashing red, something central banks in major economies haven’t had to fight for a few decades. Furthermore, their toolkit is only able to influence demand, not supply, and there is much debate around the proportion of inflationary pressures emanating from demand, and that which comes from supply, for example the oil price.
Secondly, there is a complex trade-off between growth and inflation. Specifically, the opaque relationship between the degree to which economies are already slowing and how much residual inflationary pressure remains.
In such a difficult environment, it’s no surprise that all central banks are struggling, albeit in different ways. The Fed is under pressure to retain credibility around forward guidance after adjusting to a big hitting 75bps hike at the last minute. The BoE, on the other hand, appeared more cautious, with a small 25bps rise last week, especially as it doesn’t meet again until August.
Meanwhile, the European Central Bank called an emergency meeting last week, in part to address fragmentation risk, where the more economically fragile southern economies are more exposed to higher borrowing costs. The Bank of Japan in many ways is the odd one out, as it continues to target 25bps for the 10 year yield. If this breaks, it could push yields higher globally. So, all very unsynchronised responses but all under pressure.
Looking further forward, markets are assuming around 3% for UK base rates and 3.5% for US fed funds by the end of the year. Whether this occurs or not is unclear, what is clear though is that the response from central banks will not be pain free, whether that’s the negative impact on employment or on the economies of southern Europe, for example. Remember too, that markets are more comfortable understanding the impact of interest rates but less comfortable digesting what quantitative tightening means for asset markets.
So, elevated policy risk, with a focus on credibility, has a number of key implications for markets. We have already seen volatility pick up across assets, with some degree of dislocation across markets. Indeed, it might well be that reduced credibility means policy has to go further than otherwise it would have had to, as a fall in credibility reduces their power.
For now, markets are giving central banks the benefit of the doubt. For our part, we remain cautious across portfolios but vigilant and ready to deploy cash if policy risk falls for an extended period.