MUNIX COMMENTARY – WEEK OF 15 March

In the middle of the pack

Sometimes the planets are aligned. This was a week when half a dozen central banks made their decisions and provided signals about the direction for monetary policy. The Bank of England’s meeting needs to be seen in that broader context.

Much the most important pronouncements for the world economy followed from the two-day meeting of the US Federal Reserve. As expected, there were no changes to interest rates or its bond buying program; more significant changes were made to the economic forecasts and the so-called “dots” where individual Fed governors indicate the likely future path for interest rates.

Bearing in mind the recent massive stimulus packages from Congress, it was no surprise to see a major upgrade to US growth forecasts for 2021 – GDP up 6.5% would be the fastest in 20 years – which will ripple through the world economy. The Fed was at pains, however, to emphasise that this was not expected to have major implications for future inflation. Indeed it is paying just as much attention to the state of the labour market – the overall signal is a committee happy with an economy running hot so as to bring employment, especially for ethnic minorities, up to an acceptable level. Underneath the soothing words of Jerome Powell that interest rates would not rise before 2024, however, it was noticeable that the majority of the governors actually saw rates moving up in 2023 or even late 2022.

After considering a lot of news and comments, the financial markets made up their minds. The the logic of easy policy for a long time to come is seen as positive for equities, negative with US dollar, and negative for US bond prices. The Fed can control the short end of the bond curve, but this simply results in a steeper yield curve as the benchmark bond moves up again towards 1.7%. This ripples through to other markets; for example the German 30-year bond approaches pre-pandemic highs, despite a slow growing economy beset by vaccination programme delays. The UK 10-year gilt at 0.9% is returning to summer 2019 levels.

Other central bank decisions attracted less headlines but still matter as they show the pressures which some economies are under. Brazil and Turkey hiked rates because of a weak currency, whilst Norway indicated that policy would be tightened later this year as the vaccination program and the impact of higher energy prices ripple through its inflation forecasts. Japan and Russia will also announce decisions.

Against that background the views of the UK’s Monetary Policy Committee show a central bank happy to be in the middle of the pack. No changes in interest rates or the QE programme were announced, just as expected. The window to introduce negative rates has been closed unless there is a major deterioration in the national health emergency. The Bank emphasised that policy was on hold until there are clear signs of inflation pressures – and indeed that is the key issue facing most policymakers over the coming year 12 months. All the signs are that there will be a noticeable uptrend in headline inflation in most countries into the autumn. As vaccination programs and stimulus packages take effect, causing consumer spending to shift from durable goods to services, so supply constraints and bottlenecks should become apparent. This will occur against the backdrop of sharp increases in commodity prices, especially oil, adversely affecting year-on-year comparisons. Forecasts of 3 to 4% headline inflation are not uncommon.

However, central bankers are loath to run the political risk of snuffing out a recovery before it becomes established. Hence, the emphasis that inflation will be transitory, and banks will not base policy on forecasts but respond to real time data.

Further ahead, of course, headline inflation should fall back; after all there are still sizeable output gaps in economies, exemplified by high levels of unemployment. Most companies are more concerned with cost control than generous wage rises. The difficult situation for many

policy makers will be in the next upcycle for inflation into 2022, when inflation expectations begin to suggest that central bank targets will be exceeded.

Before then “taper“ and “twist“ will be the order of the day; we have already seen the ECB and Australia’s RBA take action to restrain the uptrend in bond yields. Although there were no signals from the Bank of England, and indeed the Fed chair has dismissed the possibility of any tapering in 2021, it must be expected that central banks will act through their bond buying programs if they feel borrowing costs are moving in a disadvantageous manner, or excess liquidity is rippling through to asset prices in a dangerous manner.

In summary, 2% US benchmark yields are the next big target according to the technical analysts. With the short end fixed, so the yield curve is its steepest since 2015. Other bond yields are following suit, including gilts, meaning we see more chance of ‘twist’ type operations to cap the rise. It is entirely appropriate that fixed income markets are looking ahead to a normalisation of economic activity and then monetary policy – the issues for central banks are how quickly these moves take place.

Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial ma;ers and should not be considered as financial advice in any form.