Against a backdrop of a broadly unchanged economy and outlook, a hawkish tone from several central banks is pushing real rates higher, at the wrong time.

Policymakers for the Bank of Canada, the Bank of England, the European Central Bank (ECB), and the Fed have provided a variety of hints that reasoning for a more aggressive stance may be influencing central bank thinking. This is far from uniform; the Bank of Japan remains determinedly dovish, and there have been some important dovish messages from individual central bank members, including regional Federal Reserve Bank Presidents James Bullard and Neel Kashkari. Nevertheless, central banks, along with the Bank for International Settlements, have made some common points in these communications. Following the more hawkish commentary global rates have risen, led by European rates: 10-year bunds rose more than 30 basis points in about a week. Many fixed-income assets in the Risk Appetite Index were clustered near zero, and the worst performing were inflation-linked bonds, because real rates rose more than nominal rates.

Unwillingness to underestimate inflation
One point to note is that central bankers have pointedly dismissed recent weakness in inflation as temporary. The ECB has also drawn comfort from a slight upward move in a variety of measures of underlying inflation, even though headline measures remain subject to the vagaries of global energy prices. Rather than repeat our recent observations about inflation, it’s important to stress that there is no automatic link between an inflation forecast and an interest-rate decision. What matters for policy rates is what central bankers want to matter for rates. The Fed, in particular, seems wedded to the notion that the ever-tightening labor market must push up wages and inflation. With this model in mind, the Fed is bound to dismiss as irrelevant any period when inflation falls and the labor market tightens. For the Fed, then, it’s almost as if the desire to tighten is driven by the state of the labor market, rather than the outlook for inflation.

It’s important to stress that there is no automatic link between an inflation forecast and an interest-rate decision. What matters for policy rates is what central bankers want to matter for rates.

New thinking on asset price configurations
A second interesting point is the argument that, since financial conditions remain accommodative (because equity markets remain strong and credit is easily available via banks and bond markets), the interest-rate path associated with a given desired monetary policy stance needs to be higher. The Bank for International Settlements recently published a paper on this idea, and its lead author, Claudio Borio, was one of the few heavyweight central banking officials who expressed serious concern about monetary policy and financial market imbalances before the 2008 financial crisis. We can be sure that his ideas are being at least thoroughly discussed across the G10 central banks.

The chief concern is that key central banks seem to have articulated more hawkish views recently, even though they do not have an outlook that differs from ours in any important or dramatic way.

Not quite normal, yet
While there is no consensus on the relative importance of the various channels through which monetary policy operates, it does not seem unreasonable to believe that, in a world that has been dominated by QE, central banks should be placing more weight on overall financial conditions than they do in more “normal” times. Perhaps a better way of saying this is that if asset prices currently are more important than “normal” in transmitting monetary policy to the nominal economy, then policymakers need to keep adjusting their policy variables (short-term rates and the term structure of rates through forward policy guidance) until they get the overall configuration of asset prices that they believe will bring about the desired state of the economy. Further evidence of this perspective is that the Fed has said it is puzzled by the current configuration of asset prices.

Agreeing to disagree
The chief concern is that key central banks seem to have articulated more hawkish views recently, even though they do not have an outlook that differs from ours in any important or dramatic way — an outlook that we believe does not call for such hawkishness. The Fed’s commentary has already produced an upward move in rates, especially real rates, and the more aggressive reasoning behind it suggests that the risks of a policy mistake are rising. In addition, it’s worth remembering the uncertainty surrounding the composition of the Federal Open Market Committee (FOMC) in 2018. The indications are that the White House won’t begin to think about Janet Yellen’s position as chair until the autumn and the names being floated as replacements are a bit hawkish. The weight of the opinion on the FOMC could well change next year, depending on these personnel decisions.


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While the fundamentals of the global economy remain positive, an uptick in real interest rates offers a taste of the potential for policy error.