– Ronald Reagan
It will be time to sound the battle cry when, as William Dudley said, there is a “sustained rise in medium-term inflation expectations.” Inflation expectations need be stable if the Fed is to keep its zero interest rate policy in place. The Fed has said as much, including inflation expectations among the three conditions it has said “are likely to warrant exceptionally low levels for the federal funds rate for an extended period.” The other two are low rates of resource utilization and subdued inflation trends. Because neither of the latter two conditions are likely to change anytime soon, inflation expectations are the only game in town, and the Fed is watching them closely. The 5-year/5-year for inflation-indexed securities (see Chart 2) is said to be the most widely followed inflation expectations gauge within the Fed: It gauges where investors expect 5-year inflation expectations embedded in 5-year TIPS (Treasury Inflation-Protected Securities) to be in five years (for a total horizon of ten years).
Another call to arms would come if some of the more than $1 trillion of bank reserves currently held on deposit at the Fed begin to seep out, via an increase in bank loans. The Fed, because it houses the reserves, is a virtual Yucca Mountain, containing “toxins” that have potential to fuel inflation.
In either case, the Fed will act when it is confident that the benefits of waging war against inflation will exceed the costs. For now, the Fed feels it is not yet time, and there is a gap between its expectations, which, based on the Fed’s macroeconomic model of the U.S. (“FRB/US”), point to hikes beginning in mid-2012, and that of the financial markets, which are priced for hikes to begin by early 2012 (Chart 3).
Today, central banks face fights on several battlefields, and deciding where to pick their battles is complex. In the final analysis, central banks will choose to fight their archenemy, inflation, whenever it lurks, because a beneficial trade-off between accelerating inflation and employment does not exist. The strategoi will have to move away from policies designed to combat emergency conditions and take the role of generals, assuring the public of their readiness for the next battle.
Across the Pond and Around the World
Now let’s turn to my PIMCO colleagues for discussions on central banking throughout the world. Their comments are a regular feature of the Global Central Bank Focus.
European Central Bank Focus
Are the ECB’s Hands Tied?
Jean-Claude Trichet, President of the European Central Bank (ECB), announced last month that “strong vigilance” is needed to ensure price stability. Thank goodness. In pre-announcing a likely tightening of monetary policy next month, President Trichet broke ranks with other major central banks by acknowledging the risks to headline inflation posed by loose monetary policy and rising commodity prices. While that is welcome, the disparity of economic performance in the euro area will constrain the ECB in both the means and extent to which it can normalize policy.
At one end of the spectrum, German industry is booming, its business confidence is surging, employment is rising and public sector unions are repeatedly striking for higher wages. Although negotiated wages are only rising moderately, a rate increase by the ECB would send an important signal to wage negotiators that monetary policy won’t tolerate inflation. That will help keep wage demand in check.
At the other end of the spectrum, banks in Greece and Ireland remain highly dependent on central bank liquidity to refinance short-term liabilities, owing to their governments’ loss of market access. At close to €250 billion, banks in these two countries alone now consume half the liquidity provided by the Eurosystem, including emergency lending assistance to Irish banks. The ECB will continue to utilize full allotment auctions at its refinancing operations until these addicted banks find other sources of liquidity, which could take years. An increase in the Main Refinancing Operation (MRO) rate, to 1.25% for example, in combination with full allotment auctions will mean the Euro Overnight Index Average (EONIA) rate will continue to trade well below the official policy rate. This is suboptimal.
Furthermore, the extent to which the ECB can increase the MRO rate will be constrained by vulnerabilities in Spain and Ireland, owing to the floating rate structure of their mortgage markets. Any interest rate increase by the ECB will be passed directly to mortgage borrowers, reducing their disposable income and threatening the nascent domestic demand in these economies already constrained by tight fiscal policy. These headwinds will temper the extent to which the ECB can validate the 2%–2.5% EONIA rate priced in to forward markets for early next year
How can the ECB resolve this dilemma posed by such a disparate economy? It has three options. First, it could tighten only a bit and let demand in the core countries spill over to the periphery via the trade balance. Second, it could validate the forward markets and risk breaking something in the periphery. Third, it could maintain an accommodative stance so as not to stymie the very fragile recovery in private sector credit growth, while relying on tighter fiscal policy in the stronger, core countries to temper aggregate demand. It was precisely this lack of coordination between monetary and fiscal policies during the latter half of the last decade, coupled with lax macroprudential supervision, which led to the unsustainable build-up of private sector debt in the periphery. German taxpayers might not like tax increases or expenditure cuts, but given their memories of hyperinflation, they should also welcome a reduction in the public debt. We think the ECB will err toward the first option.
Bank of England Central Bank Focus
Is the Cat out of the Bag?
The last weeks have marked a decisive shift in the majority view of the Bank of England’s (BoE) Monetary Policy Committee (MPC). Previously its focus was on “risk management,” or put another way, a focus on maintaining growth and activity and minimizing the risk of re-entering recession. However, during that period the CPI (Consumer Price Index, the official measure of U.K. inflation) numbers have remained stubbornly high, consistently above the BoE’s target and rising. There are a well-known set of one-off effects that have caused this, so I will not repeat what many have ably pointed out already. Rather, I would like to address whether the committee has “gone soft” on inflation.
During the press conference accompanying the release of the February inflation report, BoE Governor Mervyn King was repeatedly asked whether, with the benefit of hindsight, the MPC should have already hiked rates. In response he was quite clear that during this challenging period, the cost of bringing down inflation to target would have been so high that even if he had this time back again, he would do the same thing. He is right to have said this.
However, the problem the MPC now faces is that in the New Normal of lower domestic real activity and strong emerging market growth, the volatility and uncertainty over future headline CPI is likely to remain. Even in its new, more hawkish guise, the MPC continues to give the inflation outlook the benefit of the doubt. Based on the committee’s assumed path of rates going 50 bps higher this year and 1.1% higher in 2012, it has indicated that CPI will be at or just below the 2% target by 2013.
Committee members rightly acknowledge the wide array of risks around this baseline, not least the upward risks to inflation, and the downside risks to growth. As such the MPC is taking a gradual approach to raising rates, and could certainly not be accused of rushing into a change of focus. However, the challenge remains that CPI continues to surprise on the upside, and there are some signs of upward momentum within the more domestically oriented service sector.
The MPC may well be right to take a cautious approach to hiking rates, not least because the growth outlook is so uncertain. While this is a valid approach to the broad management of the economy, it continues to suggest that the medium-term profile for CPI remains at best “an” input into the policy-setting framework rather than “the” input into the policy-setting framework. As an economist I think this is the right approach; as a bond investor I have to be more concerned. The MPC members may not have gone soft on inflation but they certainly look a little squidgy.
Other European Central Banks
Guiding the Forward Market
Central banks in Europe each have their unique way of communicating monetary policy strategy. The Swedish central bank, the Riksbank, signals the projected path of its central bank rate (the “repo rate”) in a message that contains a careful assessment of other central banks’ policy rates as well as forward market expectations. The Swiss central bank, or SNB, aims its policy rate (three-month Libor in Swiss francs) within a target range but uses an inflation forecast curve to endorse its most probable course of future monetary policy.
European monetary policy strategy follows a price stability mandate that advocates transparency and guidance on future price developments, and central banks communicate price stability via two measures: the effective policy rate and the forward rate. The effective policy rate conveys monetary conditions; it’s a daily signal of how much excess liquidity will be available to the marketplace. The forward rate reflects expectations of central banks’ future policy intentions and is based upon a published forecast curve. Together, the forward rate and forecast curve form a channel, which is dynamic since the central bank can amend its forecast at any time and thereby influence forward rate expectations.
The shape of this channel differs among the European central banks (see Chart 5). Whereas the channel narrowing in the early part of the forecast cycle could indicate a start of tightening as the front end of forward curves adjust upward (the SNB), a narrow channel in the latter part of the cycle could signal acceleration of existing tightening as the medium-term forecast is upgraded and forward expectations adjust accordingly (Riksbank). The forward rate channel is relevant for projecting monetary policy decisions.
The Riksbank recently raised its repo rate by 25 basis points (bps) to 1.5% and stated its projected repo rate path would be adjusted higher by the end of the forecast period. And at its recent policy meeting, the bank indicated the prospect of accelerating inflation could mean the pace of tightening might have to increase beyond the 25 bps hikes per meeting priced in by the markets. By indicating willingness to accelerate tightening, the Riksbank narrowed its forward rate channel further out in time. The Swedish krona appreciated, which created an indirect benefit of damping the effect of imported inflation on overall domestic inflation. Such currency strength may, later in the cycle, allow the Riksbank to moderate the pace and amount of rate hikes cooling economic growth.
In its December policy statement, the SNB boosted its inflation forecast curve modestly upward for 2011, thus narrowing its forward channel for mid-2011 and signaling the potential start of a tightening cycle. SNB President Hildebrand highlighted the signal by stating that policymakers can’t afford to mistime the reduction in excess liquidity, as low short-term rates pose a risk to price stability. The statement helped strengthen the Swiss franc, thereby reducing inflation pressures and providing a window of opportunity for the SNB to carefully withdraw the massive excess liquidity.
The Riksbank and SNB make independent interest rate decisions from each other. Their respective forward channels, however, are connected through a monetary policy strategy they have in common: price stability. It is a relationship that uses communications to widen interest rate differentials to gain relative currency appreciation, especially when commodity prices rise sharply. The resulting currency strength allows for a more carefully engineered and deliberate tightening sequence in a rising inflation environment. As such, we could expect a gradual rise in policy rates over the medium term for each of these key central banks.
Emerging Markets Central Bank Focus
The recent rise in food prices coupled with risks to energy prices due to contagion from the Middle East crisis have renewed the world’s attention on inflationary risks in emerging markets (EM), and many are asking whether emerging markets central banks are behind the curve.
Emerging markets as a whole have seen a modest rise in headline inflation in recent months, with headline CPI in the 20 largest emerging markets increasing to 5.1% (year-over-year) in January from 4.3% just six months prior. At the same time, core inflation has been relatively well-behaved with limited signs of contamination from higher headline inflation (see Chart 6), and most emerging market central banks are only modestly out of line vis-à-vis their projected or targeted annual inflation rates.
So is there really anything to be concerned about on the inflation front?
First, inflation momentum has been accelerating, with headline inflation across EM increasing 7.2% quarter-over-quarter (qoq) in January vs. a 3.9% qoq increase six months prior.
Second, headline inflation, rather than core inflation, tends to be of greater relevance for emerging markets given the higher share of food and energy in the CPI basket and the greater impact of headline inflation on wage negotiations and hence second-round effects.
Third, commodity price increases have historically led both headline and core price increases. The implication is that the impact of increases in global food and energy prices are yet to fully pass through to core inflation. Moreover, the speed of global commodity price increases along with the disruptions experienced by emerging markets in the food price boom in mid-2008 highlight the macroeconomic risks which could develop rapidly.
Finally, closing output gaps across emerging markets suggest a demand-pull aspect of inflationary pressures together with limited excess capacity compounding any supply-drive inflationary shock (see Chart 7).
The combination of these four factors point to growing inflationary risks for emerging markets precisely at a time when surging capital flows and a muted global recovery encourage EM central bankers to be cautious in implementing an aggressive hiking cycle.
So are EM central banks behind the curve? Looking at output gap and inflation trends, there appears to be some inflation accommodation by EM central banks in favor of growth and more depreciated exchange rates. Chart 7 shows that headline inflation is currently half a percentage point higher than in previous periods when the output gap was closed, e.g. 2005–2006. In other words, inflation is higher even though the economy is at the same stage of the business cycle.
At the same time, nominal rates are significantly lower now. To date, EM central banks have reversed only a fraction of the monetary stimulus implemented during the crisis. Most central banks remain on hold while those who have started a tightening cycle remain cautious and are relying more on hawkish language and macroprudential measures than policy rate hikes.
Examining trends in real rates by region sheds further light. Chart 8 shows that while real rates in emerging Europe and Latin America are increasing, real rates in Asia are close to zero and much lower than in the post-Lehman phase of the global financial crisis. This, together with robust growth of 8%–9% and unsterilized currency intervention, is driving the stronger inflationary momentum in that region.
Together these trends suggest that nominal rates in emerging markets ultimately will have to move higher and faster than central bankers are currently willing to accommodate. Local bond markets have already started to price in flatter yield curves and a gradual hiking cycle in EM. What remains to be seen is whether the sharp acceleration in commodity prices in the midst of the Middle East crisis forces the issue and brings forward the rate hiking cycle.
Australia Central Bank Focus
Australia continues to be the so-called economic battleground between the divergent influences of developed and emerging markets. Australia’s initial conditions of fiscal and monetary flexibility, accompanied by a relatively clean banking sector, bore almost no resemblance to those of the majority of developed countries. This fiscal and monetary policy freedom was effectively utilized to successfully avoid a recession in Australia.
Unlike all other developed market central banks, the Reserve Bank of Australia (RBA) has already had to navigate a New Normal policy tightening cycle. In hindsight, the appropriate prescription appeared to have been fairly obvious, but at the time of their first hike in October 2009, the global economic trajectory was a lot less clear.
Quickly rebuilding policy (both fiscal and monetary) firepower is key for Australia to be able to deal with any future crisis with equal success. Using similar thinking, the RBA began their tightening cycle in October 2009, saying “ … the Board’s view is that it is now prudent to begin gradually lessening the stimulus provided by monetary policy. This will work to increase the sustainability of growth in economic activity and keep inflation consistent with the target over the years ahead.”
Due to the floating rate nature of the vast majority of Australian mortgages, the transmission mechanism of policy rate changes to the real economy is very rapid. During the global financial crisis, the RBA specifically took into account the higher cost of funding across the banking system in setting their cash rate, requiring lower rates than would have been the case prior to the crisis. The RBA has now raised rates by 175 bps to 4.75%, and mortgage rates have risen by roughly an additional 120 bps above that since 2008.
Despite the cash rate only having reached 4.75%, vs. the previous cycle low of 4.25%, the RBA specifically states “the [current] stance of monetary policy... has resulted in interest rates to borrowers being close to their average of the past decade.”
In addition, the RBA understands the secular impact of Chinese demand will drive long-term structural change in the Australian economy. The increasingly infrastructure-oriented nature of China’s economy and the associated increase in bulk commodity prices has directly benefited Australia via the terms of trade. While the RBA has raised the policy rate seven times so far in this cycle, they have specifically taken into account the Australian dollar’s strength when setting the policy rate.
PIMCO continues to believe the RBA will raise rates to 5% in the second half of 2011, implying a slight tightening bias vs. our New Normal neutral rate expectation, which would be approximately 4.5%.
Portfolio Manager, Market Strategist
Head of Portfolio Management, Germany
Head of Sterling Portfolio Management
This material contains the current opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.