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Bank of Canada Governor Tiff Macklem in Ottawa on April 13.BLAIR GABLE/Reuters

This was the week central bankers looked flustered and stock markets looked panicky. But, hey, it wasn’t all bad news.

On the plus side, markets continued to function smoothly. In contrast to the financial crisis of 2008, there was no hint that unsuspected weaknesses are lurking deep within the crevices of the financial system.

Instead, investors are grappling with a problem that lies in plain sight – inflation. The question that hangs over everything is just how high interest rates must rise to tame the biggest inflationary outburst in decades.

Unfortunately, policy makers appear just as baffled by this head scratcher as everyone else is. The most unsettling aspect of this past week was the growing evidence that central banks are still scrambling to catch up to the spreading impact of surprisingly persistent inflation.

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First came an emergency meeting of the European Central bank on Wednesday. Policy makers rushed to offer reassurances that the bank would find a way to come to the aid of heavily indebted euro zone countries hit by rising borrowing costs.

That was followed within hours by one of the most unusual Federal Reserve meetings in memory.

The Fed, the world’s most powerful central bank, had long been guiding the market toward expecting a 50-basis-point hike. (A basis point is one hundredth of a percentage point, so a 50-basis point hike amounts to raising rates by half a percentage point.)

An ugly inflation report on Friday, June 10, appears to have abruptly changed the Fed’s mind. Policy makers concluded that stronger medicine was needed and decided to supersize their hike to 75 basis points.

The challenge they then faced was that the Fed is supposed to go into a silent period before important meetings. So how could the central bank communicate its sudden change of heart and not shock financial markets? It looks as if someone decided to leak the news to The Wall Street Journal, which published a story on Monday declaring that a 75-basis-point hike was on the table.

The leak ensured the surprise 75-basis-point hike was no surprise at all when it actually came to pass on Wednesday. But talking to a newspaper reporter is not how important policy decisions are supposed to be revealed.

The jury-rigged process left many Fed watchers shaking their heads and wondering about the long-term damage to the central bank’s credibility. “Future Fed attempts to signal policy direction will be countered with, ‘They don’t mean it, remember June 2022?’” Paul Donovan, chief economist at UBS Global Wealth Management, warned in a note.

The most charitable way to view the Fed’s flustered performance is to point out that a rolling barrage of calamities over the past two years has taken everyone by surprise. First, came the initial pandemic lockdowns. Then, just as they were easing, came a new wave of COVID infections from Delta and Omicron variants, as well as the shutdown of major parts of the Chinese economy. This was followed by a completely different kind of shock – Russia’s invasion of Ukraine. That has sent oil prices and food prices rocketing higher.

Bond markets have been no better than central banks in getting ahead of the bad news. Since the start of the year, key bond yields in both Canada and the United States have doubled as investors have rushed to keep up with an inflationary surge that refuses to fade.

Higher bond yields are now beginning to bite the real economy. One casualty is the stock market, which is taking a hit as rising bond yields offer an increasingly tempting alternative to equities. Another casualty is residential real estate, which is suffering as mortgage rates rise in tandem with bond yields.

“The outlook for house prices is worse than we previously feared,” Stephen Brown, senior Canada economist at Capital Economics, warned in a report Thursday. He sees house prices tumbling by 20 per cent.

Is a recession next? Not necessarily. Consumers still have lots of savings and the jobs market remains strong.

However, the probability of at least a mild downturn is rising. In both Canada and the U.S., the gap between the yields on 10-year and two-year government bonds has narrowed to a tiny fraction of a percentage point. When this gap disappears and short-term bonds enter an unusual patch in which they start paying more than long-term ones, a recession often follows.

The silver lining in all this, if you can call it that, is that markets still seem confident that central banks will triumph over inflation. Breakeven rates, which measure inflation expectations by comparing yields on conventional bonds to yields on inflation-protected bonds, show that the bond market expects inflation to average 2.6 per cent a year over the next decade. This is slightly above the Fed’s 2-per-cent target but not seriously so.

Investors appear to be betting that the Fed and other central banks are not going to blink when it comes to hiking interest rates. Policy makers will do whatever it takes to ensure inflation won’t linger, according to the bond market. Or to put that another way, the floggings will continue until inflation improves.

This is somewhat reassuring. However, central banks don’t control oil prices or food prices. If those prices spiral higher, the only way for the Fed and the Bank of Canada to control inflation would be to engineer deflation in the parts of the economy they do have more control over.

That would be a bumpy process that could involve even more painful interest rate hikes than are currently contemplated. If this week’s action is any indication, central bankers could find themselves as surprised by how things turn out as any of us are.

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