Entering a new month, a new quarter and the second half of the year, the market theme is turning to the prospect of central bank tightening, and in particular how the transition away from quantitative easing (QE) to more normalised monetary policies is going to be managed. The last week has seen a number of confusing statements from central bankers about this subject causing the markets to react.
First and foremost, there is the US Federal Reserve which appears to be undergoing something of a change in its approach to policy setting. Janet Yellen, the Fed chairwoman, caught the markets attention at the start of last week when she said she thought asset valuations are "rich" although she went on to say she does not believe there will be another financial crisis. She stressed that the Federal Open Market Committee (FOMC) is not targeting asset prices particularly, and said the markets have well anticipated a gradual rate hike path, especially as the Fed has made it clear that rates will rise only gradually.
This is only partially true, however, as the Fed’s dots imply another interest rate rise this year, with three to follow in 2018, but the markets are barely pricing only one rate hike over that whole period. Part of the problem is the Fed no longer seems as data dependent as it used to be. In the past this meant that its policy decisions were driven by developments in the economy and in inflation, but more recently it appears the Fed’s expectations and the data have become detached. The Fed has been looking for a strong rebound in second quarter growth after a soft first quarter, with the mere expectation sufficient to keep the Fed biased to hike. Meanwhile, the US Economic Surprise Index continues to decline and is at its lowest level this year, and bodies like the IMF are lowering their forecasts for the US economy.
Mark Carney, the governor of the Bank of England (BoE), also muddied the trajectory for UK rates by saying the BoE could debate raising rates in the coming months. Mr Carney pointed out that if spare capacity tightens in the UK, the bank would not be prepared to accept over-target inflation levels and hence would need to tighten rates. This stance seems to reverse Mr Carney's view earlier this month that it was not the time to raise rates as the UK follows through with the process of Brexit. The view from Mr Carney also seems at odds with those of the deputy governor of the BoE, Jon Cunliffe, who said last week that higher inflation was hitting consumer spending and that he was waiting for improvements in business investment before supporting a rate hike from current levels of 0.25 per cent. Three members of the MPC voted to raise rates at its last meeting and as recently as a fortnight ago Andy Haldane, the BoE's chief economist, said he would also endorse a rate hike.
If confusion at the BoE was not enough for markets to handle, the ECB managed to cloud the picture further. The ECB President Mario Draghi commented that "while there are still factors that are weighing on the path of inflation, at present they are mainly temporary factors that typically the central bank can look through". These were interpreted by investors as paving the way of a withdrawal of the ECB’s monetary stimulus.
However, ECB officials subsequently said Mr Draghi's comments had been misinterpreted by markets and that an automatic change to the ECB's stimulus measures in response to inflation levels was not guaranteed. The unnamed officials blamed the recent downturn in inflation on lower energy prices. Regardless of such caveats the markets have heard enough to suspect that some kind of policy change is afoot.
Markets have responded to the sudden change in emphasis by central banks with an increase in bond market volatility, as investors attempt to judge the timing and scale of a move towards a more "normalised" monetary policy after a prolonged period of QE and negative rates. For now, questions about whether central banks are right to be talking up tightening risks are largely being overlooked. But with the US and the UK economies appearing to be softening, it may not be long before the justification for such messages comes under closer scrutiny.
Tim Fox is chief economist & head of research at Emirates NBD
