Traders are increasingly convinced that surging prices will force central banks to tighten. And posthaste.
Comments from Andrew Bailey over the weekend and a hot inflation print out of New Zealand stoked rate hike bets and pushed up yields Monday in a fairly dramatic bout of bear flattening.
During a virtual panel discussion, Bailey conceded that central banks can’t combat the supply chain bottlenecks contributing to surging input prices, but forcefully suggested that policymakers should act to short-circuit the expectations channel. He cited spiraling energy prices which “raise for central banks the fear of embedded expectations.”
He then made it explicit: “That’s why we, at the Bank of England have signaled, and this is another signal, that we will have to act.”
Two-year UK yields rose as much as 17bps at one juncture (figure below), while money markets priced in 15bps of tightening in November and 34bps by year-end.
The fireworks came less than a month after a policy meeting that skewed decidedly hawkish.
Note that the recent rise in global bond yields began in earnest on September 23, when the BOE telegraphed a possible acceleration of tightening measures just hours after the Norges Bank delivered a rate hike.
The BOE expects inflation to hit 4% in the near-term before retreating thereafter (figure below).
Five-year yields in the UK rose as much as 14bps. Traders are also pricing in an ECB hike. Try not to laugh. Money markets now see Christine Lagarde and co. hiking 10bps in September 2022.
Similarly, markets now expect RBNZ to follow up on this month’s hike with another OCR increase in November. Monday’s inflation data showed prices rising 4.9% YoY (figure below), well ahead of expectations for a 4.2% increase.
The quarterly gain, at 2.2%, was the largest since Q4 of 2010. “Excluding quarters impacted by increases to GST rates, the September quarter movement was the highest since the June 1987 quarter,” Statistics New Zealand remarked.
To the extent central banks do “act,” it’ll be an effort to disabuse the public of the notion that policymakers are either asleep at the wheel or else too “woke” to care about inflation unless and until the labor market heals completely from the pandemic shock.
The problem is glaringly obvious. Rate hikes can’t fix broken supply chains. And they can’t supply more natural gas. Or bring down coal prices. And on and on.
Potentially, tighter policy can prevent inflation expectations from becoming unmoored, but that’s a psychological phenomenon. One way or another, consumers need to see actual evidence of lower prices. The only way central bank action can facilitate that is by engineering demand destruction, which is just a nice way of saying policymakers could deliberately push economies into recession.
Don’t worry, any engineered recession will be transitory 😉
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So the choice for CBs, according to Mr. Bailey, is to do nothing (a bout of stagflation) or raise rates into a slowing economy (engineered recession). Given the amount of leverage in the system, which of these is likely to result in a black swan event?
Unfortunately at this point I think both. If they keep the support up then inflation keeps growing as the scarce resources demand higher and higher prices. In which case shortages of goods becomes very painful for many. OR they could hike rates and engineer a recession which due to the extreme leverage in the system would destroy lots of theoretical wealth and likely result in some perverse results as demand tanks and the global supply chain cuts capacity further. This would be extremely painful for many.
The issue is at this point it’s kind of like debating which way you should adjust rates to deal with a literal gunshot wound… it’s not actually going to address any of the fundamental issues. Policy is what we need. We need sustained investment in onshoring and incentives for making supply chains more robust. We need laws that prevent prioritizing shareholder value on a daily basis over basically any other value. We need infrastructure investment. We need to update the education system. We need to provide meaningful debt relief. We need to build sufficient affordable housing. And on and on. None of which interest rates going up or down will do.
“as demand tanks and the global supply chain cuts capacity further“
Wealth destruction may dent the marginal consumption of the wealthy but what about for those without wealth?
K shaped inflation shows that demand is outstripping supply for necessities. Food, autos, energy, housing. It’s hard (though not impossible) to destroy demand for those through interest rate policy. And if demand for those products doesn’t tank why would capacity be reduced?
Inflation, when measured in pounds and in the UK, is a serious concerns. Brexit has adversely affected the UK and will continue to do so. As for the dollar, I don’t think inflation is as serious a concern. Why does anyone care about the UK and BOE? They are in a special situation and are becoming less and less important to the world economy.
I harbor a nostalgic concern for what is happening in the UK but cannot ignore the fact that Brexit was a self-inflicted wound and pray that the post-Brexit fallout serves as a cautionary tale for policymakers here.