Part of me doubts this needs restating, but given the historic nature of the circumstances, it’s worth reiterating: Central banks don’t want easier financial conditions right now.
In fact, it’s not too much of a stretch to suggest that any session during which financial conditions ease represents a setback in the inflation fight. Wednesday was very instructive in that regard.
September 28, 2022, will be remembered as the day the Bank of England was compelled to intervene in the UK government bond market to avert a catastrophic pension fund collapse. It may also be remembered as the day when the first developed market central bank blinked in a yearlong, three-way staring contest between policymakers, inflation and markets.
Soundbites and testimonials from those on the frontlines made it abundantly clear that absent the BoE backstop, Wednesday might’ve been enshrined in the annals of history for a mini-Lehman moment. As such, I think it’s probably fair to say the bank had good reason to intervene.
And yet, the ripple effect across global markets spoke to the inherent tension between intervening to prevent a calamity and risking counterintuitive price action that could work at cross purposes with efforts to tighten financial conditions and bring down inflation.
Most obviously, the optics around an intervention financed with money printing (or whatever euphemism you prefer) are very poor at a time when inflation is near double-digits, and fiscal policy is off the rails. I went over that on Wednesday morning.
Beyond that, note that Wall Street came into Wednesday riding a six-day losing streak. You’re reminded that the majority of the FCI easing impulse witnessed post-pandemic came courtesy of the stock rally. Although one session doesn’t negate a 22% drawdown, large equity gains do ease financial conditions. And Wednesday’s rally was the largest since the release of the July CPI report and before that, Jerome Powell’s timid press conference following the July FOMC meeting (figure below).
That’s counterproductive. The Fed needs lower stocks and not just because of the immediate impact on some bank’s financial conditions index. The higher stocks go, the more emboldened consumers lucky enough to own them will be. That risks more spending — more demand. The Fed is expressly attempting to curtail demand.
Next, have a look at US real yields, among the Fed’s most potent weapons in turning the proverbial screws. Five-year reals fell ~30bps on Wednesday (figure below).
The steep decline was the largest since the aftermath of the June FOMC meeting, prior to which reals surged as markets attempted to price in the largest US rate hike since 1994.
That’s a “pure” FCI easing impulse. Or, put differently, the last thing hawkish policymakers want to see.
Finally, note that the dollar had its worst day since August 10 (figure below), the same day the cooler-than-expected CPI report annotated in the first figure (above) drove a big equity rally on Wall Street, as traders speculated on a Fed pivot.
Although I’ll be the first to say that a little dollar weakness isn’t the worst thing in the world at a time when the greenback’s inexorable trek higher threatens to undermine entire economies as import bills surge, and the US exports stagflation, the point is simply to note that the Fed’s efforts to bring down domestic inflation are hampered when the dollar drops.
It’s no coincidence that commodity prices, which had fallen to an eight-month low on Bloomberg’s spot gauge, jumped the most in six weeks. Five-year breakevens rose Wednesday.
Of course, the BoE wouldn’t dare describe its efforts to preserve market functionality and prevent a UK pension collapse as indicative of a new foray into large-scale bond-buying for the purposes of stimulating the economy. And the Fed would aggressively push back on the idea that the BoE’s decision has any implications at all for US monetary policy.
“The Bank of England’s decision to intervene in the gilt market is directly a result of the government’s fiscal plan, but also a symptom of the fact that gilts don’t benefit from being dollar-denominated in the same way Treasurys do,” BMO’s Ben Jeffery and Ian Lyngen said Wednesday, noting that the combination of labor market strength and still high inflation will ultimately dictate the Fed’s actions. “This by no means precludes other periods of market strain and other central banking intervention around the world,” they added. “But with domestic employment still strong we don’t anticipate this will derail the Fed’s tightening.”
It’s possible that additional action like that taken by the BoE Wednesday would actually embolden the Fed’s tightening efforts, to the extent it drives counterproductive price action. That is of course unless the Fed starts to ponder the relative merits of taking a pause out of concern for global spillovers and the potential for “events” overseas to boomerang. The Committee could always lean on the “long and variable lags” argument if they needed some cover. Unfortunately for the rest of the world, though, Fed officials pretty much boxed themselves in with the September dot plot. And so far anyway, this week’s rhetoric is unabashedly hawkish.