By Mohamed El-Erian for Bloomberg
Although the Bank of England kept interest rates unchanged, it reminded traders and investors on Thursday that they had been underestimating the probability of a hike this year. This is similar to the approach that the Federal Reserve used effectively six months ago, and that it may return to after next week’s Open Market Committee policy meeting.
Whether it is for the U.S. or for Europe, predicting central bank policy actions is tricky, given today’s unusual mix of economic, geopolitical and economic fluidity. There are important questions about how economies behave, from the relationship between inflation and unemployment to the evolving determination of productivity and wages. Geopolitical concerns come and go, particularly North Korea’s periodic missile threats. Meanwhile, domestic politics on both sides of the Atlantic has struggled for years to fully step up to economic governance responsibilities and, in the case of the U.K. and the European Union, clarify the future regional architecture.
In this environment, it should come as no surprise that central banks have been eager to maintain considerable policy optionality and flexibility. After all, they too are puzzled by key economic relationships that they were confidently modeling not so long ago. They too are trying to understand ongoing structural shifts, including technological innovation and changing cross-border relationships. And all this as they continue to carry the burden of dealing with the consequences of a growth model that still relies excessively on debt, credit and central bank liquidity; and as they wait for politicians to progress on pro-growth measures, both on the supply side and when it comes to a more balanced demand management policy stance.
This mix has led central banks to be highly “data-dependent” and to err repeatedly on the side of being looser for longer. With a consequential repression of financial volatility, asset prices have surged higher in an impressively broad-based manner. And the (unusually infrequent and short) pullbacks have been quickly offset by an investor base conditioned to “buy the dip” on the demonstrable hypothesis of continued liquidity injections, particularly from central banks. In the process, markets have also tended to pull down the implied path of interest rates well below those signaled by central bankers.
But even a good thing can go too far (and, over the longer-term, it is far from clear that the intense codependence that has formed between markets and central banks is a good thing). As such, central banks are getting less comfortable about how markets price their future actions, and how this may increase the risk of financial instability down the road.
On Thursday, the Bank of England surprised market consensus with a relatively aggressive policy guidance that suggests it would hike rates in November in the context of a gradual and limited rate cycle. As going into the meeting, traders and investors had placed a very low probability of such an action, the pound immediately shot up and the market repriced higher the yield curve for U.K. government bonds. It was reminiscent of what the Fed did last March when, through a well-executed sequence, it led markets to increase the probability of an impending rate hike from 30 percent to more than 90 percent in a remarkably short period of time.
The Fed will likely consider doing the same again, but only after it gets through the Sept. 19-20 FOMC meeting. Rather than seek to aggressively reprice market expectations of the future path of policy rates, the central bank will focus its attention next week on detailing the approach to a very gradual reduction in its $4.5 trillion balance sheet.
Thereafter, and before the Dec. 12-13 meeting, Fed commentary is likely to remind markets that policy formulation is based on more than just worries about lowflation. With developments in the labor market pointing to less slack, and with (admittedly less explicit) worries about the rising risk of future financial instability that could undermine growth, Fed officials will seek to use policy guidance to push up the implied probability of a December rate hike to at least 50 percent. That number would shoot higher if, working with the administration, Congress were to signal a higher likelihood of early action on tax reform and infrastructure; and it would slip sharply if North Korea’s brazen provocation were to evolve into something more serious.
For some time, markets have been lulled into believing that central banks will be their BFFs (best friends forever), helping them overcome all sorts of “unusual uncertainty;” and that has been a highly rewarding investment strategy. But it is also a configuration that makes central banks inherently uncomfortable and increasingly anxious. The Bank of England reminded us of this Thursday. It is only a matter of time before the Fed does the same.