European Central Bank (ECB) officials seem irked that they are not being taken seriously by markets - risking a show of force in Frankfurt that may seem at odds with a struggling euro economy.
As August consumer price numbers revealed a picture of only slow, sticky euro zone disinflation and ECB hawks warned against halting rate hikes prematurely, money markets stuck doggedly to bets the campaign is at least on pause, but more likely over.
After 425 basis points (bp) of ECB policy rate rises to 3.75% over the past year, that market take seems uncontroversial given a halving of headline inflation since October, business activity contracting again for three months in a row, credit tightening and economic surprise indexes consistently negative since May.
But with inflation still more than twice the target, and long-term market expectations - like those in the U.S. - settling in on a 2.5% landing zone rather than the stated 2% goal, some officials fear ECB credibility is being challenged and that may infect price setting in the wider economy.
To be fair, the level of uncertainty on what happens next - both within the major central banks and the investment world - is high and rising. Long-term visibility is unusually low.
But without pre-judging the next rate move, and detailing a screed of upside and downside risks to the price, ECB board member Isabel Schnabel on Thursday took a jab at interest rate and bond markets - key conduits of ECB credit policy - for undermining the central bank’s work.
Specifically, she outlined puzzlement at why the inflation-adjusted risk-free rates priced by markets - real Overnight Index Swap yields from one to 10 years - had subsided again since the last ECB rate hike in July - back to where they were in February when ECB policy rates were just 2.5%.
“This decline could counteract our efforts to bring inflation back to target in a timely manner,” she concluded, insisting that just holding rates here higher for longer was not a substitute for even more restrictive policy if warranted.
Also spotlighting a dispersion in private forecasters’ inflation outlooks to show a ‘fat right-hand tail’ indicating a significant probability of inflation settling above 2.5%, she stressed the ECB could not commit to ending its campaign yet.
ONE FOR THE ROAD?
Schnabel’s broadside against market pricing mirrors a conundrum for all central banks about how to prevent financial markets betting rate hikes are over and loosening credit conditions in the wider economy prematurely before inflation is sustainably back on target.
Given the lags in how policy rates hit the economy - due mainly to delays with which fixed-rate loans like mortgages are refinanced at the new higher rates - central banks risk overshoot and overkill if they keep tightening until their actual target is reached.
It’s then a judgment call on when enough sedative has been already administered, while engaging in a verbal sparring match with banks and bond markets to stop them adding adrenaline before the medicine takes full effect.
That battle appears set for trench warfare over every basis point, if Scnabel’s detailed metrics are anything to go by, and hinges not only around imponderable economic and political developments over the coming months but also loose assumptions of sustainable rates over time.
Long-term real yields from benchmark German government bond markets are positive again this year for the first time in almost a decade. But they have fallen almost 20bp from just before the last ECB rate hike to just above 0.1% now.
If assumptions are correct that the theoretical ‘R-star’ real level of interest - one which would sustain growth and on-target inflation over time - is still negative in the euro zone, then real bond yields are still, just, restrictive.
The euro’s trade-weighted exchange rate is also almost 5% stronger for the year to date - even though euro zone stock markets are also up 10%.
But although well off early August highs of around 2.7%, market inflation expectations contained in the euro 5-year, 5-year forward inflation swap remain stuck at 2.5% - up more than 10bp from the start of the year despite 125bp of ECB hikes.
If it’s deemed essential that these expectations - and by extension those of wage bargainers and companies pricing goods - are nailed back to 2%, then the verbal jousting is either going to have to go up a gear or the ECB will have to turn the screw again.
Minutes released today from the last ECB meeting suggest the council is still undecided about its next step this month, but many market analysts see the tension building.
“For the hawks, the risk might be too high that a pause could actually transform into an actual full stop,” wrote ING economist Carsten Brzeski.
“This is why we think the hawks will have their final say and push the ECB for a final dovish hike at the September meeting. A last one for the road, even if it remains a very close call.”
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