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"Now you can’t always get what you want"

- Rolling Stones

This week has caught our eye from a central bank perspective. While the overwhelming narrative is to continue to pledge that monetary accommodation will be in place until the respective recoveries are ‘well under way’ (and by means of validation are making at the very least ‘significant further progress’ towards inflation and employment mandates), we are increasingly of the view that the global monetary easing cycle has run its course. Thus, as the recovery takes hold, it is likely that there will be an increasing focus on the reaction function of central banks, as market focus shifts towards the process of rate normalisation… at some point.

I am not suggesting that rate hikes are just around the corner (apart from perhaps some specific EM economies - Turkey and Brazil?), but financial markets and FX in particular are driven by differentiation. As the global reflation process evolves, it will do so at differing speeds and will be dictated by the relative strengths of global economies (and their pre-existing conditions - or strengths and weaknesses from before the pandemic), not just the technical growth rebound from reopening sectors of the economy. By extension, and most significantly for the monetary policy debate, the recovery will drive global differentiation in inflation and inflation expectations. I will return to this point shortly.

Over recent days we have heard from several central banks:

(i) The Bank of Canada left rates and QE unchanged, pledging to maintain extraordinary support for the economy, but its Governor Macklem added that “Canada won’t need as much QE over time under the base case”;

(ii) Bank of England’s (BoE) Governor Bailey highlighted that the “transmission of rates if negative or near zero is unclear” and that the BoE has not taken the decision or indeed “discussed” negative rates;

(iii) Brazil removed the dovish forward guidance from its monetary policy statement in a move that likely opens the pathway to higher rates - at least in part to counter the (unexpectedly?) continued fiscal profligacy;

(iv) the Bank of Japan countered speculation from earlier in the week that they may loosen YCC and enable long end rates to rise, but, despite the near term virus concerns, stated that “Japan's economy is picking up as trend… business investment has stopped falling… prices will eventually start rising.”

All very subtle I admit, but the start of a slow process of monetary normalisation. With one potentially notable caveat: the ECB. Going into this week’s meeting, there was very little in terms of expectation regarding changes to policy or the narrative from the Governing Council (GC). In broad terms, these expectations were fulfilled. However, there were some subtle points that I feel deserve some attention.

The statement offered a ‘reconfirmation’ of the additional policy measures announced at the December meeting. However, it was in the press conference where the message appeared to become less clear.

The minutes of the December meeting (published last week) included the view from within the GC that “lowering yields further may have negative side effects”, but the tone of President Lagarde’s dialogue purposefully emphasised the fact that the ECB stands ready to adjust all tools, going on to state that the ECB pledge to keep rates unchanged at “present or lower levels until inflation has robustly converged to its medium term target, and such convergence has been consistently reflected in underlying inflation dynamics” – the clear inference being that growing discomfort with a rising EUR warrants the emphasised threat of a lower deposit rate.

The uncertainty was heightened further by the line in the statement that “If favourable financing conditions can be maintained… the [PEPP] envelope need not be used in full” or could be “recalibrated if required”. On my count, this topic drew five questions (or sub questions) in the Q&A - each time with the same response that failed to clarify under what criteria such decisions would be made. However, much of this vagueness (on rates and PEPP) can be put down to the divergence of views on the GC and Lagarde’s style of being more spokesperson, than leader.

While the market responded to the PEPP envelope “need not be used in full” by selling Bunds (and intra eurozone spreads), the real question that still remains unanswered from my perspective is how the ECB expects to generate inflation. Not the technical adjustment due to the expiry of the German VAT cut, but actual demand driven price pressure, with monetary policy already at levels so extreme that GC member diverging views make it difficult for Lagarde to offer a credible threat of lower rates or even the full utilisation of the PEPP envelope - at least not without further substantial fiscal boost - when the eurozone fiscal outlook for 2021 is for a modest contraction, not expansion.

In the US, the prospect of a further Biden fiscal stimulus plan has been clearly driving inflation expectations. However, if you strip out commodity price inflation from 5Y5Y forward inflation expectations in the eurozone, it is not clear that there is any domestic aggregate demand driven price pressures, or expectations.

Finally, if convolutedly, I get to the point I wanted to make. As the global economy navigates a way past the pandemic, financial markets can begin to look to monetary normalisation. Yet this process is likely to contain significant differentiation. Brazil is expected to hike rates by almost 300bps this year (for idiosyncratic reasons), the US under a Biden boost may begin to generate inflation (and expectations) that drive rate hike expectations significantly closer than currently priced, as may eventually other commodity exporters and even the UK. But for the ECB, the inflation undershoot is an acute and maintained concern (“risks remain to the downside”).

Lastly, while Lagarde noted that “government bond yields play an important role in pricing credit in an economy” (despite the fact that the current QE programmes distort the credit valuation in the name of monetary policy transmission), a normalisation of monetary policy would necessitate the removal of support for peripheral credit spreads through the argument for ‘monetary transmission’. This adds to the complexity of the normalisation process for the ECB - and likely further adds to the duration of support. This complicated balancing act argues for EUR headwinds into the future - if not, as Lagarde inferred she may like, in the near term!

Sources
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