MIKE DOLAN: The world’s central banks’ gamble

London — A touch reluctantly maybe, but the world’s big central banks seem to be leaning towards a short, sharp policy squeeze now in the hope they can back off quickly once they’ve made that mark.

The Bank of England’s quarter-point interest rate rise — the second time since December — was widely forecast amid mounting pressure for it do something to clip a UK inflation rate that could top 7% during the northern hemisphere spring.

But the UK central bank was just one swing vote away from lifting policy rates by 50 basis points — what would have been the largest rate rise since 1995, two years before the BoE gained operational independence 25 years ago.

What’s more, the narrow 5-4 split against such a steep rise came even as the Bank cut its three-year inflation forecast to as low as 1.6% — a rapid unwind far below its 2% target.

And while money markets now see the Bank lifting its 0.5% policy rate another percentage point to 1.5% by year-end, only one more quarter-point rise is priced for 2023.

BoE chief Andrew Bailey’s plea to markets not to get ‘carried away’ by the chance of more rate hikes has been partly heeded — even if another four more hikes this year would bring UK rates to the highest since the aftermath of the global banking crash 13 years ago.

And with that sort of shock in the works, the market outlook gets murkier after that — reflecting both the likely economic fallout, the Bank’s inflation forecast and probability it will need to halt the process rapidly.

The gap between 2-year and 10-year UK bond yields and equivalent money market and swap rates over the same horizon are now sliding — with 10-year gilt yields now just 21 basis points higher than the 2-year and the sterling overnight index swap curve over those maturities negative to the tune of 22 bps.

The BoE may seem like an outlier, being the first of the G7 central banks to lift interest rates since the pandemic.

But markets have also wondered if the US Federal Reserve will also consider an unusually large 50bp start to its tightening cycle in March — front-loading a short series of hikes and allowing balance sheet reduction to do the heavy lifting in later years as policy rates return quickly to pre-Covid-19 levels.

Thursday’s European Central Bank set-piece showed it well behind the other two — but it faces similar pressures to bring forward tightening and markets reacted accordingly.

“The risk is that central banks are being forced to respond to the here and now, rather than lay out a policy path incorporating forward looking measures of growth and inflation,” said Georgina Taylor, multi-asset fund manager at Invesco.

Taylor added that the implication of the BoE “manoeuvre” — hiking and signalling pressure for more while cutting its inflation forecast — meant it would either have to stop hiking quickly or risk a ‘policy mistake’ damaging the economy.

This creates problems for national currencies trying to consider whether rate tightening can be sustained.

HSBC’s strategists insist the extent of UK tightening jammed into money markets could act as a drag on sterling.

“This may make it harder for the BoE to deliver an overall tightening cycle that matches market expectations, creating a longer-term drag for the pound,” they told clients.

Trapped in headlights

So why are central banks minded to take the risk if they still think inflation will subside?

For many, it’s just a gamble rather than any scientific calculation. After all, higher interest rates can’t do much to cut inflation as they won't boost the supply of oil and gas or cut energy prices midwinter and they can't magically create more microchips or bring more workers back to the labour force.

Brutal interest rate rises today could swamp demand of course. But deliberately triggering recession around what most policymakers still think is a temporary post-pandemic distortion may seem perverse.

The simplest hope is that stamping a foot now convinces price-setters and wage bargainers that decades high inflation rates won't last — preventing supply-distorted price spikes looping ever higher as firms and households scramble to dodge 'real' inflation-driven losses.

An added bonus may be to more quickly drain some of the emergency support money sloshing around the financial system since the pandemic rescues, helping stifle any risk of a credit explosion while slowly deflating potentially destabilising bubble-like asset markets.

But why the hesitation? Noboby’s been here before.

Pandemic lockdowns and reopenings are not normal economic cycles and it’s impossible to make any prediction with confidence. What appear as tight labour markets are still in thrall to wild swings in workforce participation or migration. And the energy price direction is even fuzzier — subject to anything from geopolitics to climate policies while registering gigantic annual base effects.

The ECB’s apparent foot-dragging compared to the other two is at least understandable. Who proves correct won’t be known for months or even years.

But for global liquidity specialist CrossBorderCapital the hawkish shift should already spell trouble for investors.

“History suggests that a major liquidity slump lies ahead,” it told clients this week. “With equities trapped in the headlights, bond markets are likely the best counsel for investors.”

The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own

Reuters