Rates Spark: The battle to keep policy tight

As the European Central Bank’s (ECB) Sintra conference get underway, central bankers will have their eyes firmly on two important checks on their recent hawkish charge. Firstly, a deterioration in economic outlooks, illustrated by the plunge in Germany’s Ifo index published yesterday, limits the credibility of any aggressive hawkish tone with markets fearing a recession. Secondly, it is not altogether certain that, in isolation, a more hawkish central bank results in materially tighter financial conditions.

The central banks’ sphere of influence typically doesn’t reach very far up the curve

The first concern can in theory be addressed by a single-minded focus on backward-looking inflation. This is the strategy adopted by most central banks, also justified by their poor track record in forecasting inflation. By and large, this strategy has been successful in delaying rate cut expectations, but the central banks’ sphere of influence typically doesn’t reach very far up the curve, so the economic outlook still matters. Dhingra and Tenreyro have an easier job communicating the Bank of England’s stance when they speak today, given the UK’s entrenched inflation problem. Things are more challenging for Lagarde given the deterioration of European economic data.

The second, related, point is that it is debatable how much central banks can really tighten monetary policy on their won in a data-dependent regime. There has clearly been a reappraisal of global central banks’ reaction functions in June, but the result has been much flatter yield curves. To the extent that this is a symptom of higher short-end rates and unchanged long-end rates, this is a net tightening of financial conditions, an albeit a disappointingly limited one. The problem arises when, even as short-end nominal rates rise, long-end real rates drop. Taking EUR 5Y5Y real rates as an example, they have dropped 40bp since their peak a month ago, hardly a tightening of financial conditions.

Tighter sovereign and credit spreads suggest the cost of funding remains affordable for the economy

What’s more, risk assets have taken the recent change of central bank tone in their stride, see for instance the spectacular tightening of sovereign spreads. The ECB may well gush that its policy stance is well transmitted, tighter sovereign and credit spreads suggest the cost of funding remains affordable for the economy. This is good news, but also suggests that a more hawkish stance is needed to yield results, but with increasing downsides. This is the choice faced by central bankers at this week’s Sintra conference: chase the diminishing returns of a hawkish stance, or accept that a lot of the financial variables responsible for ultimately supressing inflation are beyond their control.