For some time now, the world’s leading central banks have had a credibility problem. Having insisted that the surge in inflation stemming from the Covid-19 pandemic was temporary, policymakers fell behind the curve and were forced to raise interest rates more sharply and at a faster pace than would otherwise have been the case had they acted sooner.
Even after the most intense monetary tightening cycle in decades, the average core inflation rate – which strips out volatile food and energy prices – in advanced economies stands at 4.3 per cent, according to JPMorgan data. This is only slightly more than 1 per cent below its level at the end of last year, when fears about stagflation were rife. It is also more than double the 2 per cent target of many central banks.
Perhaps more worryingly, central banks’ “forward guidance” – communication about the future course of monetary policy – has been severely compromised. This is partly because of the uncertainty over the outlook for inflation and interest rates, but mainly because central banks have lost control of the narrative.
While policymakers say their decisions are data-dependent, the reality is that they have little confidence in their own forecasts. Not only did central banks grossly underestimate the staying power of inflation, they also did not anticipate that labour markets would prove so resilient in the face of dramatic rises in borrowing costs – a key factor keeping prices elevated.
Nowhere is this more evident than in the United States, whose economy has defied gravity. The excess savings households built up during the pandemic have powered consumer spending, keeping growth relatively buoyant.
People walk past a restaurant with a hiring sign outside in Washington on October 5. Hiring in the US private sector rebounded in October, with education and healthcare creating the most jobs. Policymakers are eyeing the pace of job growth as they work to rein in inflation by lifting interest rates to cool demand. Photo: AFP
For financial markets, central banks’ unclear and unreliable guidance about the policy outlook, coupled with a raging debate over how long rates are likely to remain high, have proved a nerve-racking experience and caused extreme volatility in asset prices. The uncertainty, moreover, has made investors highly sensitive to even the slightest indication of a policy shift.
Expectations that the leading Western central banks will cut rates next year have reached fever pitch in the past month. Swaps markets are pricing in reductions in borrowing costs in the US, the euro zone and Britain as early as May, even though all three central banks insist it is too early to declare victory on inflation.
Investors’ expectations are understandable to some extent. Headline inflation rates have fallen sharply while global manufacturing and services sector activity is on the verge of contracting, according to the latest survey data compiled by JPMorgan and S&P Global. This is putting pressure on central banks to loosen policy.
However, this is not the first time markets have priced in rate cuts because of fears about an over-tightening in policy that could precipitate a recession. According to a report published by Deutsche Bank on November 15, investors have anticipated a dovish pivot from the Fed seven times since the rate-raising cycle began, only to have their hopes dashed by stronger-than-expected growth and inflation.
Central banks might have lost credibility, but wild swings in markets are just as damaging, and perhaps more. Predictions of looser policy earlier this year – at the height of the banking turmoil in the US in March, markets were pricing in rate cuts before the year’s end – quickly gave way to a dramatic repricing when it became clear to investors the Fed was not yet done tightening policy.
US Federal Reserve Board Chairman Jerome Powell delivers remarks after the Fed refrained from raising interest rates following its two-day conference at the Federal Reserve in Washington on November 1. It is the second consecutive time the Fed has left interest rates unchanged as it tries to tamp down high inflation. Photo: EPA-EFE
Such unwarranted and disruptive moves in markets have grave consequences for the economy, particularly the rate-sensitive property sector.
In Hong Kong, which imports US monetary policy through its currency peg to the US dollar, the impact has been severe. The one-month Hibor rate – the main reference rate for mortgage loans – shot up from 2.8 per cent in mid-April to 5.3 per cent by mid-August, driving up mortgage rates and causing prices and sales to fall sharply. Britain’s mortgage market has also been hit hard by mispricing in debt markets.
Hong Kong home prices to fall by 10 per cent in 2024, UBS forecasts
If central banks are flying blind, it stands to reason that markets are even more unsure about the outlook for inflation and rates. Investors who are betting on sizeable reductions in borrowing costs next year should pay more attention to three crucial factors.
The first is that core inflation is what matters. Wage growth and the price of services remain far too high for rate cuts to be on the table any time soon. Moreover, the nightmare scenario for central banks is jumping the gun, particularly given that their credibility has already suffered greatly.
The second is that a pause does not signify an impending cut. The Reserve Bank of Australia raised interest rates earlier this month following a four-month suspension of its tightening campaign. Australia’s inflation rate used to be significantly lower than in Europe and the US, but now core inflation is higher and wage growth is accelerating.
The third factor is that rate cuts are much more likely to materialise if there is a recession or another major shock to the global economy. Either scenario would dash hopes for a soft landing. Investors should be careful what they wish for.
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