Slow-Motion Central Bankers Put Their Maestro Status on the Line

The world’s most powerful central bankers sound like they’re in no rush to speed ahead on their new inflation-fighting path.

In the U.S. and Eurozone, central banks have pivoted toward monetary tightening in recent weeks—but they want to take it slowly, even though prices are rising at the fastest pace in decades. That suggests they still see choking the recovery and eliminating jobs as the bigger risk, after persistent unemployment last decade stoked political turmoil across the Western world.

The Federal Reserve and European Central Bank (ECB) continue to add stimulus to their economies. They’ve been reluctant to end their asset purchases on the spot or to signal a faster pace of interest-rate hikes, preferring to stick with the same step-by-step policy guidance that they used in the low-inflation years before Covid.

“They are implicitly making a choice about the distributional effects of their policy,” says Derek Tang, an economist with Monetary Policy Analytics Inc. in Washington. “They would rather have a hot economy and higher inflation than a large number of people stuck out of work.”

With some big central banks like the Bank of England weighing faster moves, many investors and economists say the go-slow approach—coming from institutions that claim to be data-dependent—doesn’t square with evidence that suggests an inflation emergency. The apparent mismatch is roiling markets.

Yields on two-year U.S. Treasury bonds have jumped more than 70 basis points (bps) since December, as traders bet that the Fed has fallen behind the curve and will be forced to play catchup. In Europe, forward rates imply multiple hikes this year, despite the ECB emphasizing that it’s in no hurry.

‘Implicit Choice’

Policymakers acknowledge that their settings need to change soon. At the ECB, consensus is starting to build that interest rates will likely rise at the end of the year, while Fed officials aren’t pushing back against market expectations for a series of stair-step hikes.

But they also see all kinds of risks from overcorrecting.

The pandemic has made it hard to forecast even the near future. It’s created new problems, like inflation driven by supply-chain breakdowns, that can’t easily be fixed with monetary tools. But central banks can at least argue that a repeat of the jobless recovery of the 2010s has been avoided. And they want to keep it that way.

“You can’t tell people you lost your job” because microchip and car prices were high, says Tang. That “would challenge the credibility of the institution” even more than lingering high prices.

While central banks have backed away from the idea that pandemic inflation is “transitory,” they’re still trying to look beyond the immediate Covid crisis. Both the U.S. and Europe have ageing populations and may need to draw more people into the workforce. Slowing job growth now could make it harder to do that later.

‘Abrupt and Aggressive’

The strategy is fraught with risks. There’s no guarantee that central banks can maintain public trust in their ability to keep inflation low in the longer run. The distributional question cuts both ways: Critics say easy-money policies are driving up the prices of assets like stocks and housing, making wealth gaps wider. And if the 2010s showed how sustained unemployment can be fertile ground for populist movements that challenge governing institutions, history suggests sustained inflation can have that effect too.

For now, what the Fed and ECB are saying is that they’re determined to deliver on their targets —but won’t rush headlong into the fight.

“Abrupt and aggressive action can actually have a destabilizing effect on the very growth and price stability we’re trying to achieve,” San Francisco Fed President Mary Daly said on the CBS News show Face the Nation on February 13. “The most important thing is to be measured at our pace.”

ECB President Christine Lagarde explained that higher interest rates can’t resolve supply-chain problems or lower the price of fuel. “If we acted too hastily now, the recovery of our economies could be considerably weaker and jobs would be jeopardized,” she said in a February 11 interview published on the ECB’s website.  “That wouldn’t help anybody.”

Markets: ‘I Don’t Care What You Say’

In the coming weeks, both central banks could come under pressure to explain more precisely what they mean by a policy shift that isn’t abrupt or hasty.

Investors aren’t clear on that point. In the U.S., futures traders are pricing in six or seven rate increases this year, compared with three or four just a month ago, but there’s a lot of divergence among forecasters. European markets see two quarter-point ECB hikes this year, where they didn’t even price one in mid-January.

“Markets are starting to say, ‘I don’t care what you say. What are you going to do?”’ said Mark Spindel, chief investment officer at MBB Capital Partners.

Meanwhile, yearend inflation forecasts for both the U.S. and Eurozone have been steadily rising.

If price increases hit a peak over the next few months and cool down appreciably after that as supply problems fade, central bankers will be able to claim a maestro moment. It would be a victory for policy that prizes a discretionary approach, one that balances goals in the pursuit of low inflation rather than prioritizing it over every other consideration. Central bankers would likely acquire another layer of monetary mystique.

If they fail, and inflation continues to run too hot in the second half of this year and beyond, then pressure will build—from politicians and markets—for more decisive action.

That could force central banks to tighten financial conditions more than they want to, at the risk of choking off demand and ending economic recoveries.

Central banks “are trying to walk a tightrope,” says Blerina Uruci, an economist at T. Rowe Price in Baltimore. “This ambiguity of where policy is going is setting us up for more volatility in the months to come.”

—With assistance from James Hirai.

 

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