Central banks running too fast or too slow?

Short dated bonds have aggressively repriced as inflation expectations rise and fears creep in that central bankers maybe heading towards a policy mistake as longer dated maturities are not rising as fast and yield curves flatten. So will a crash come from moving too fast or too slow?

The U.S. September Consumer Price Index (CPI) report indicating that inflation may be less “transitory” than the Federal Reserve (Fed) initially expected, and employment data points towards a tighter labor market, investors are starting to debate whether the Fed is falling too far behind the curve when it comes to hiking rates. Meanwhile, in the UK, the combination of firm overall growth, a strong labor market, and intense supply and price issues is putting pressure on the Bank of England (BoE) to raise rates sooner. The market expectation now is for the BoE to raise the official cash rate as early as their November meeting.

Will the Fed move too slow?

The debate on whether the Fed should bring their rate hike forward was sparked by recent U.S. economic data releases that suggest that the above-trend inflation we have been experiencing may linger for longer. Most notably, the CPI report showed that higher home prices are starting to filter into inflation, with owners’ equivalent rent increasing by 0.4% month-over-month, the largest increase since 2006. This is important not only because rent accounts for more than one-third of the CPI weighting, but also because it tends to be stickier and more inertial than other components such as food or energy. It is also important because there is a strong historical relationship between the unemployment rate and shelter inflation, with tighter labor markets tending to lead rising rental prices, suggesting that labor markets may be tighter than the employment report indicated.

However, it would be impossible to ignore the fact that most of the strength in inflation this year prior to the September release was focused on pandemic-related goods prices, rather than services. As the economy reopens and consumers start allocating more of their spending to services, the demand for goods may moderate. This demand transition, coupled with the eventual resolution of supply chain disruptions (see our previous paper “Are we entering a period of stagflation?”) should relieve some of the inflationary pressure we have been seeing in 1H2021, and this should help to bring headline inflation closer to the Fed’s 2% long-term target.

Before concluding that the Fed should tighten monetary policy sooner, it is important to note that tightening just to curb goods demand may be unwise given that demand may eventually subside and supply side dynamics may improve. It would be worth waiting until after the Fed starts the tapering process to observe whether the broadening of inflationary pressure we saw in the September data will still persist.

Will the BoE move too fast?

In the UK, curbing inflationary pressures is made even more difficult by the fact that the BoE targets headline inflation, which has been higher due to the surging energy prices. BoE governor Andrew Bailey warned that the central bank will “have to act” to curb inflationary forces and warned that higher energy costs will cause inflationary pressures to linger. He also noted that while monetary policy is not effective in countering supply disruptions, policymakers should avoid allowing higher inflationary pressures to become entrenched as it has so far this year. As the chart illustrates, the 5-year 5-year measure of inflation expectations has risen to its highest since 2010 in the UK. Governor Bailey’s comment is the latest in a series of attempts by BoE officials to lay the groundwork for a potential rate liftoff in November, which would make the BoE the first major developed market central bank to raise rates following the pandemic.

Investors are concerned that this tightening is premature, worrying that this will stall the recovery momentum. A key parallel drawn by these investors was the rate hike by the European Central Bank in 2011 following the global financial crisis (GFC) and during a raging debt crisis, where they had to cut them merely four months later. However, it is important to differentiate the current situation from that of 2011. While government austerity was a major factor behind the weakness in nominal activity after GFC, governments now appear to be more willing to turn to fiscal spending and have great ambitions to “build back better”. As such, it could be wise for the BoE to start tightening gradually to respond to evolving medium-term inflation risks.

Investment implications

As corporate profits usually rise along with prices, equities offer a hedge against moderately rising inflation. Though we are seeing nominal yields climb, real yields are still firmly in the negative territory given the higher inflation expectations. Deeply negative real rate should continue to support equities on equities on relative valuations. However, higher yields could put more pressure on those parts of the market which are highly valued as forward earnings are discounted at a higher rate.

A steepening of the yield curve as growth fears fade is positive for the more cyclical- and value-oriented parts of the equity market as they are historically positively correlated with yields and poised to benefit from the post-pandemic recovery.

Within fixed income, an active approach as yields are expected to continue rising. Investors can tackle the challenges from duration risk and rising yields by looking for fixed income assets with short duration, or low sensitivity to rising rates. High yield bonds and selective emerging market fixed income can also help generate return from their relatively high coupons.