Fynsa
Last week's crisis in the United Kingdom served as a reminder of just how dependent markets are on central bank support and the dilemma they face in maintaining market stability in the face of persistent inflation.
Striking a balance between fighting inflation and maintaining financial stability is a challenge that central banks have not faced in recent decades, and the BoE (Bank of England) had to “pause” its fight against inflation to restore financial stability following the sell-off in the bond market and the collapse of the British pound, following announcements of a highly expansionary fiscal policy that included massive tax cuts (which threaten to create fiscal imbalances and further exacerbate inflation problems) , with many wondering whether the U.S. Federal Reserve might soon be forced to do the same.
Of course, the BoE’s intervention prevented UK assets from entering a crisis (and avoided contagion to the rest of the world), but the emergency monetary policy response—in the form of bond purchases—did not solve the underlying problem, namely, the highest inflation rates in decades.
It is in this context that the market is beginning to doubt whether central banks around the world will continue to take aggressive action to combat inflation as risks to financial stability mount. Of course, this has led to some risk-taking in recent days, based on the assumption that this time we will indeed see the long-awaited “policy pivot.”
However, recent experience has shown that it was not a good idea (and, moreover, a rather costly one) to bet on a pause or shift in monetary policy. You may recall that equities rebounded by more than 10% starting in the second half of July, the dollar tended to weaken, and the rise in market rates paused somewhat, as investors bet on “a Fed pivot”—only to give back those gains and more a month later when the Federal Reserve reaffirmed its commitment to doing whatever it takes to rid the economy of excessively high inflation, even if that comes at the cost of slower economic growth. (SEE MORE HERE).
It’s true—a lot has happened since July. Financial conditions have become more restrictive, with interest rates up by nearly 100 basis points, the dollar up 5 percent, and a monetary policy that is projected to be strictly restrictive going forward. Growth prospects have continued to deteriorate, the yield curve is more inverted (indicating rising recession risks), inflation expectations have moderated, and labor market imbalances appear to be starting to correct. And we could add some evidence of increased “financial stress.” In other words, unlike in July, we may now be closer to a “peak” in terms of policy.
The problem is that actual inflation—and especially core inflation—is proving to be far more persistent than expected, and this has forced the Fed to stand firm on the need to continue tightening policy to reduce inflation. The point of contention today is no longer so much how high rates will go (there is a certain consensus that U.S. federal funds rates will reach 4.5%–4.75% by the end of this year and early next year), but rather how long rates will remain at those levels before beginning to fall.
The market continues to price in rate cuts for 2023 , and the Fed, through various interventions this week, has tried to dissuade the market by stating that it does not plan to cut interest rates next year.
How will this story play out? So far, it has been a bad idea to go against the Fed; therefore, just as happened between July and August (SEE MORE HERE), we do not think it’s wise to bet on a policy pivot—at least not until we have more evidence that actual inflation (particularly core inflation) and the labor market begin to show some weakness (the data coming in over the next few weeks will be key in this regard), or until the observable “cracks” in the financial markets (the United Kingdom, Credit Suisse, an unstoppable dollar, liquidity, and high volatility in the debt markets) ultimately tip the scales in favor of financial stability.
