By Jose Torres
International organizations such as the United Nations have criticized central banks’ aggressive monetary policies to combat inflation. These organizations fear that the current level of synchronous tightening by central banks could result in financial hits that could contribute to significantly lower global economic growth prospects.
Higher interest rates in developed countries are weakening emerging market currencies, making it more expensive for those nations to service debt and buy dollar-denominated commodities, weakening economic output.
Additionally, higher interest rates in developed markets are causing money to flee emerging markets as investors chase higher “risk-free” yields in US Treasuries or other safe-haven assets in developed markets, which also hampers economic growth. While central banks take global implications into account when conducting monetary policy, they tend to largely prioritize their own responsibilities, to the disappointment of the United Nations.
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However, in recent weeks, some central banks have taken dovish measures, including the following:
The Reserve Bank of Australia delivered a surprise rate hike of 25 basis points, down from the 50 basis points the market was expecting.
Last month the Bank of England responded to the troubles in the gilt market by temporarily buying long-dated bonds, a dovish move from a central bank primarily determined to contain inflation.
In Japan, the BOJ has maintained its dovish stance by intervening in FX markets, buying bonds and keeping interest rates low.
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Certain international organizations want more of this because looser policies in developed countries, while inflationary, would reduce risks to economic and financial stability in emerging markets. In the European Union, on the other hand, ECB President Lagarde argues that the bank should stop stimulating the economy by slowing the reinvestment of bond coupons and further raising interest rates. The International Monetary Fund has backed firm central bank action, with Managing Director Georgieva citing global inflation as the main risk.
Here in the States, the general rhetoric has been restrictive, with examples such as the following:
Fed Bank of Richmond President Thomas Barkin noted that while the stronger dollar has the potential to weaken global economic conditions, the Fed’s focus is on the US economy.
Vice Chairman Lael Brainard warned against easing monetary policy prematurely as it could trigger a renewed surge in inflation, as in the 1970s when Fed Chairman Arthur Burns eased monetary policy too early.
Fed Bank of Atlanta President Raphael Bostic noted that post-pandemic changes in supply chains and global trade could reduce efficiency and increase inflationary pressures. He believes that companies are more willing than they have been in the past 30 or 40 years to trade efficiencies and lower operating costs for reliable and safe production, an inflationary trend.
Fed Bank of Cleveland President Loretta Mester believes the US will not face financial stability issues, current interest rates are not in restrictive territory and a US recession will not stop the central bank from raising interest rates.
Presidents Daly, Kashkari, Williams and Bullard of San Francisco, Minnesota, New York and St. Louis believe inflation is the main problem the central bank is fighting. They all support tighter policies.
Finally, Chairman Powell has transitioned from indulgent and patient in 2021 to excited and unwavering in 2022 as his comments have shifted primarily to price stability. A similar message was heard in the 1980s from the late Fed Chairman Paul Volcker, whom Chairman Powell admires for tackling a challenging problem, inflation, with unpopular means: higher interest rates and recession.
Despite dovish comments from US central banks, markets cheered the possibility of banks elsewhere easing policy as the S&P 500 index rose in early October, while most yields along the duration curve fell sharply from recent highs. The 10-year yield slipped to 3.62%, while the 2-year yield slipped to 4.1%, much lower than the 4.01% and 4.36% levels of just over Sept. 27 a week. Commodities across the board rose, celebrating hopes of increasingly dovish moves, with West Texas Intermediate Crude up 4% to hit nearly $87.
Hold on a second, if commodities are going up, isn’t that terrible news on the inflation front? Of course it is, and that’s the problem with easing policy at this point: it’s stimulating demand as well as pricing pressure. While some companies are currently prioritizing economic growth and financial stability over inflation, others believe inflation should be paramount. Ultimately, the overall sideways tilt of central banks holds the key to the direction of equity and bond markets.
(The author is a Senior Economist at Interactive Brokers)