FILE PHOTO: The Federal Reserve Building is located in Washington, United States on May 1, 2020 against a blue sky. REUTERS / Kevin Lamarque / File Photo
March 24, 2021
Posted by Mike Dolan
LONDON (Reuters) – It’s likely different this time around – or at least for policy makers and markets trying to track them.
Fuzzy Federal Reserve targets are creating a fog for other central banks and for investors who anticipate the next upswing in the interest rate cycle in the years ahead.
The new average inflation regime has not yet been tried and only the Fed has so far officially passed it. This leaves considerable uncertainty about how the Fed will conduct itself and how other countries will react to a new mandate in Washington while they are still watching the old ones.
Like it or not, the still dominant role of the dollar in global finance means that the Fed’s development is still of vital importance to the financial policy and planning of countries – especially in emerging markets, but also in developed countries.
Last year’s strategic review of inflation targets gave the Fed considerable leeway on exactly when to respond to rising inflation.
Since it is no longer strictly committed to a credit crunch if inflation exceeds the 2% target due to a new long-term averaging of this target, it can and plans to keep the economy “hot” as long as it believes the coming inflation spike will temporarily.
She stressed that she said again last week that the majority of her policymakers hadn’t seen a rate cut before 2024 and that she would not change her stance without clear evidence of a shift in long-term inflation or employment trends rather than bare ones Predictions of such.
CHART: The Fed decides on inflation expectations – https://graphics.reuters.com/USA-FED/INFLATION/bdwvkmkodvm/chart.png
All of this may make sense for America today – but it’s still a long way from how it will affect the rest of the world.
When it was launched last year in the middle of the pandemic, many believed the change would simply lead to easier money and a weaker dollar for longer.
This has its own burdens overseas – but is arguably more easily managed by emerging market central banks, who can resist the strength of the exchange rate, build hard money reserves and keep finances stable.
However, initial deliberations did not fully capture the extent of the subsequent US fiscal surge and the resulting surge in real bond yields this year, which has confused the consensus and steadily strengthened the dollar.
This primarily complicates the US perspective considerably.
After the financial markets hadn’t played this particular game, they had to make their own choices. And their guess so far, whether right or not, is that the Fed will blink sooner and hike rates as early as next year, causing real-inflationary bond yields to rise as a result.
Alongside the Hawkian edge of the Fed Council, futures pricing appears to see such loose fiscal policies leading to rapid growth, re-employment and inflation that the Fed can begin “normalizing” much sooner than is currently indicated.
“It’s a results-based test,” said Robert Kaplan, head of the Dallas Fed, on Tuesday, adding that he was one of the policy makers expecting a rate hike next year.
That foggy view, however, is creating a mess in the prospects for central banks to adjust to the inevitable flood of US conditions – with a sudden, dramatic reversal in investor flows to emerging markets this month, triggered by a surge in government bond yields .
Within a week of these outflows, the central banks of Brazil, Russia and Turkey rushed to hike interest rates during a pandemic to tackle currency weakness over the weekend and the lira on tailspin again anyway.
GRAPH: Emerging Markets Currencies Due to the Pandemic – https://fingfx.thomsonreuters.com/gfx/mkt/qzjpqlozmvx/EMFX.PNG
“Investors only gave up their bullish view of emerging markets when US Treasuries (10-year) hit 1.6%,” said Morgan Stanley’s EM team. “But the rise in USTs was a wake-up call for everyone, and investors have since become more cautious about EM.”
This second guess of the gradual evolution of Fed thinking, however, is not just an emerging market problem.
The surge in US real yields carried over to Europe, where a third wave of the pandemic is still in full swing and lockdowns are still tightening. And this has already forced the European Central Bank to step up its bond-buying program – less certain that eurozone budget spending will come close to that of Washington.
But at least the ECB already seems fair to follow the Fed’s strategy and rethink more flexible inflation targets.
The Bank of England is still theoretically tied to its government-mandated 2 percentage point inflation target, and its chief economist and others are already worrying about the hawks.
Despite a tough year for the UK economy and the trade sensitivity of oversized sterling strength, futures markets see the BoE hike rates ahead of the Fed – in part because of their now stricter mandate during a period of reflation.
GRAPH: G4 key rates – https://fingfx.thomsonreuters.com/gfx/mkt/nmopardarva/G4.PNG
“Some in the BoE’s internal camp fear a persistent overshoot of inflation, and we expect it will continue for the next few months, especially given the bank’s symmetrical inflation target,” said Deutsche Bank economist Sanjay Raja.
Offsetting factors include tighter UK financial forecasts that could allow the BoE to stay relaxed longer, Raja said.
“The bar for the BoE to tighten policy over the next two to three years may be high, but not entirely insurmountable.”
CHART: CDS rates for emerging markets over 12 years – https://fingfx.thomsonreuters.com/gfx/mkt/bdwvkmlbqvm/EMCDS.PNG
(The author is the Editor-in-Chief, Finance and Markets for Reuters News. All views expressed here are his own.)
(by Mike Dolan, Twitter: @reutersMikeD; Editing by John Stonestreet)
This article originally appeared on www.oann.com