Fynsa
Last week's UK crisis was a reminder of how dependent markets are on central bank support and the dilemma they face in maintaining market stability in the face of persistent inflation.
The trade-off between fighting inflation and maintaining financial stability is a complication 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 after the massive sell-off in the bond market and the plunge in sterling, following announcements of a highly expansionary fiscal policy that included massive tax cuts (which threatens fiscal imbalances and further exacerbates inflation problems) and with many wondering whether the US Federal Reserve might be close to having to do the same. Many are wondering whether the U.S. Federal Reserve may be close to having to do the same.
Of course the BoE's intervention prevented UK assets from going into crisis (and contagion for the rest of the world), but the emergency monetary policy response via bond purchases did not solve the underlying problem, i.e. the highest inflation rates in decades.
It is in this context that the market is beginning to doubt that global central banks will continue to be aggressive in the fight against inflation as risks to financial stability increase. This has of course prompted some risk-taking in recent days on the assumption that this time we will indeed have the long-awaited "policy pivot".
But, recent experience has shown that it has not been a good idea (otherwise quite costly) to bet on a pause or turnaround in monetary policy. You may recall that equities rallied more than 10% starting in the second half of July, the dollar tended to weaken and the market rate hike had some pause, betting on "a Fed pivot", only to give back those gains and more, a month later when the Fed reaffirmed its commitment to do what is necessary to rid the economy of too high inflation, even if this is at the cost of lower economic growth.(SEE MORE HERE).
It is true, since July to date there has been a lot of water under the bridge. Financial conditions have become more restrictive with almost 100 bp higher interest rates, 5 pct higher dollar and a monetary policy that is projected to be very restrictive going forward. Growth prospects have continued to deteriorate, the yield curve is more inverted (recession risks are increasing), 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 July, today we may 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 keep tightening to reduce inflation. The point of contention today is no longer so much how far rates will go (there is some consensus that US federal funds rates will reach 4.5% - 4.75% by the end of the year and early next year), but rather how long rates would stay at those levels before they start to come down.
The market insists on starting to price in cuts in 2023 and the Fed through various interventions this week has tried to dissuade them that they do not plan to cut interest rates next year.
How will this story be resolved? So far it has been a bad idea to go against the Fed, therefore, as was the case between July and August, (SEE MORE HERE), we don't seem to be betting on a policy pivot, not at least until we have more evidence that actual inflation (particularly core) and the labor market begin to show some weakness (incoming data these weeks will be key in this regard), or until the observable "cracks" in the financial markets (UK, Credit Suisse, an unstoppable dollar, liquidity and high volatility in the debt markets), end up tipping the balance in favor of financial stability.
