Even after central banks have come to terms with last year’s misreading of inflation, the monetary policy roadmap remains prone to error. Not only does this further damage their credibility, it repeatedly plagues the markets and undermines the economic recovery.
The US Federal Reserve is likely to hike interest rates by 75 basis points on Wednesday. This comes just weeks after Fed Chair Jerome Powell and his team repeatedly announced a half-percentage-point hike.
It’s the latest in a series of missteps by US central bankers, ranging from classifying last year’s high inflation as “temporary” to accelerating the end of the bond-buying program to accelerating the unwinding of the bond portfolio. Christine Lagarde, President of the European Central Bank (ECB), has also taken a more hawkish stance of late than she had previously indicated.
Forecast errors increase the risk of an economic recession
Investors around the world are increasingly concerned that the race to undo past forecast errors is increasing the risk of an economic recession. Global equity markets have already entered a bear market, US Treasury yields posted their biggest two-day rise since the 1980s on Monday, and credit markets are showing signs of mounting tension.
The Governing Council will hold an ad hoc meeting on Wednesday “to discuss the current state of the market”. The announcement comes after Italy’s 10-year bond yield rose above 4 percent this week for the first time since 2014. This suggests that investors are unconvinced that the ECB can hike rates while keeping bond yields from the region’s weakest members in check.
Meanwhile, the dispute between bond traders and the Bank of Japan is escalating. The Bank of Japan is struggling to convince markets that its ultra-loose monetary policy is sustainable. 10-year Japanese government bond futures fell Wednesday, the sharpest since 2013.
“Unsustainable” – This hedge fund is putting the Japanese central bank to the test https://t.co/WqyNRRIMYf pic.twitter.com/Sl1xAudVq0
— cash (@cashch) June 14, 2022
Loss of trust requires even more measures
The monetary authorities’ mistakes have tarnished their reputation for maintaining price stability and preventing the spiral of inflation that plagued middle-class incomes in the 1970s. Loss of credibility means more policy action may be needed to ease price pressures.
“Central banks are in a dilemma,” said Sayuri Shirai, a former board member of the Bank of Japan and now a professor at Keio University. “To restore confidence, central banks need to raise interest rates enough to bring inflation down, which could lead to a further slowdown in the economic recovery,” she said.
Household and corporate belief that central banks will meet their inflation targets over time is a key factor in dampening price pressures. Households may be reluctant to make some purchases as they trust prices will fall over time. And workers are less likely to include demands for subsistence allowances in wage negotiations.
Inflation expectations do not fit into the central banks’ narrative
Until recently, policymakers emphasized that long-term inflation expectations were contained. The President of the Federal Reserve Bank of Chicago, Charles Evans, stated in March that today’s inflation is not comparable to that of the 1980s. This is because an “overly loose monetary policy” in the 1960s and 1970s contributed to an increase in long-term inflation expectations.
The University of Michigan longer-term price expectations indicator released on Friday showed a clear crack in that narrative, rising to its highest level since oil prices rose in 2008.
While the Fed, ECB and their peers cannot be blamed for failing to anticipate the price hikes resulting from the Russian invasion of Ukraine or the duration of global supply chain troubles. Still, the continued expansion of their balance sheets in 2021 and the maintenance of interest rates near zero, even as inflation skyrocketed and economies recovered from the depths of the Covid-19 crisis, appears to have helped plant the seeds the current turbulence, according to the critics.
“I believe that will be a devastating blow to central banks’ credibility – when investors realize that the inflation we are facing is ‘man-made’ and central banks have played a crucial role in it,” said Stephen Jen, who runs the hedge fund Eurizon SLJ Capital in London.
It took Powell until November to retract the description of inflation as “temporary” and admitted last month that “in hindsight it probably would have been better to raise rates sooner”.
Fed estimates prone to error
Former Treasury Secretary Lawrence Summers, a constant critic of the Fed since early 2021, called the US Federal Reserve’s March inflation expectations “delusional when they are released”. The Fed’s favorite price index rose 6.3 percent on an annualized basis in April. The median of Fed officials’ estimates in March was 4.3 percent for 2022. New forecasts are due on Wednesday.
The US is not alone in struggling with a credibility problem. ECB President Lagarde and her colleagues are now on course to hike rates by a quarter point in July and 50 basis points in September. And that’s after Lagarde said in December that a rate hike was unlikely this year.
“All international institutions, all renowned forecasters have made the same mistake” by underestimating the crisis, Lagarde said last week. Australia’s central bank governor Philip Lowe in May called it “embarrassing” that his earlier forecast that interest rates would remain at record lows into 2024 had turned out to be so wrong.
The picture for emerging markets is mixed. Some, like Brazil, have raised interest rates much faster than developed countries. China has instead focused on providing monetary support amid an economic slowdown. In India, as recently as April, the central bank dismissed claims that it was too late to raise interest rates for two consecutive months. Meanwhile, inflation remains well outside its tolerance range.
The public is increasingly questioning the role of central banks
Many surveys point to a loss of public confidence in central banks:
- A Gallup poll released in May found that just 43 percent of respondents have “very much” or “quite a bit” confidence that Fed Chairman Powell will do the right thing for the US economy. While not the lowest among recent Fed chairmen, it is well below the 74 percent that Alan Greenspan received in the early 2000s.
- For the first time in history, more people were dissatisfied than satisfied with the Bank of England’s price control performance, a quarterly survey found.
- Japan’s central bank governor Haruhiko Kuroda suffered a slump in popularity after saying consumers are becoming more tolerant of rising prices. A Kyodo News poll released Monday found that 59 percent of those polled thought he was unfit for the job.
Stock market legend Stanley Druckenmiller, who runs the Duquesne Family Office, warned this month that the central bank’s policies a year ago were grossly inappropriate and it is inevitable that investors will lose money. “When you predict a soft landing, that goes against history,” said Druckenmiller, 68, who managed funds for billionaire George Soros for more than a decade.
(Bloomberg/cash)
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