October 13

Central Banks Struggle to Build Consensus

Commentary out of the world’s central banks over the last week has highlighted a growing concern about falling inflation expectations and slowing global growth. The Federal Reserve and the Bank of England are struggling to find consensus on how well their respective economies are actually doing. On the other end of the spectrum, the European Central Bank, Bank of Japan and the Peoples Bank of China grapple with the question of whether more easing will actually do more harm than good at this point. It seems that the world’s major central banks have entered a holding pattern to evaluate current policies. Their main concern for now are inflation expectations in the wake of QE ending.

It is no secret that inflation expectations in the United States have declined notably over the last month, with 5y5y forward rates falling near levels seen when the Fed initiated QE2 and Operation twist. If we recall back to 2010, the main reason Bernanke argued for more easing was a decline inflation expectations in the wake of the Greek debt crisis. This time around the reason behind falling expectations has a silver lining. Oil prices have fallen over 20% in the last three months, which undoubtedly has  affected the outlook for inflation.


It is difficult to determine how much of the move in inflation linked fixed income Is due to oil and how much is due to low demand. PIMCOs massive outflows are also likely having an effect as they liquidate positions. To a certain extent the reason may not matter to the world’s central bankers, as Mark Carney went into dovish mode over the weekend saying that “There is weaker global demand, relative to global potential. That is producing a very benign global inflationary environment and that is something that we do certainly take into account.”

If central banks do not want to raise rates, they will find a reason to avoid doing so and for now the reason has become falling inflation expectations. A few months ago the reason was “slack” in the labor market, which has seemingly decreased as of late so the new reason of falling inflation expectations has taken over. Even though the fall in inflation expectations may be due to something good (falling oil prices), central bankers seem to jump at the chance to extend the status quo even though falling expectations have not yet fed into lower realized core inflation.

Mark Carney and Mario Draghi have more wiggle room on this subject than Janet Yellen, as their respective central bank mandates focus on headline inflation while the FOMC’s duty is to manage core inflation.5y5y spreads are a preffered measure of headline inflation, so oil and food prices are responsible for a large amount of realized volatility. Actual headline inflation in the G4 economies has been volatile in recent months as oil prices have plunged, but core inflation has remained steady or ticked up slightly.  There is not enough data as of yet on the third quarter oil selloff period to determine how inflation dynamics will unfold. Given this fact, it is not hard to envision a scenario in which inflation expectations are plunging due to falling oil prices, but actual core inflation remains stable.

As for more monetary easing ,the ECB and BoJ policy committees have been locked in contentious debate over whether to embark on further easing as publicized feuds are beginning to undermine their credibility. Mario Draghi and Bundesbank President Jens Weidmann are at odds over whether to iniate a sovereign bond buying program. Both men are advocates for more structural economic reforms, but Weidmann staunchly opposes asset purchases, including the current ABS buying scheme set to start next month. Weidmann and other governing council hawks are outnumbered, but his voice carries by far the largest weight with Draghi.

In Japan, Prime Minister Shinzo Abe and BoJ Governor Haruhiko Kuroda have exchanged public comments on the effects of the weakening Yen as Abe’s approval ratings sag. Kuroda has defended his bank’s policy of asset purchases, saying that the weak Yen is a good thing for the economy on balance. Abe is a bit less forthcoming, taking up the populist angle saying that the weak Yen has hurt consumers and small businesses.

FOMC members have fired off a multitude of conflicting comments over the last week as doves on the policy committed have jumped at the chance to point out a rising dollar and slowing global growth as threats to the U.S economy. At the IMF conference over the weekend, the number two man at the Fed Stanley Fischer said – “If foreign growth is weaker than anticipated, the consequences for the US economy could lead the Fed to remove accommodation more slowly than otherwise,”

The main point throughout all of this is that central bank policy markers are collectively further from consensus on what to do next that an any point since the 2008 crisis. A loss of confidence in central banks, who themselves seem to have lost confidence in the global economic recovery is the main reason behind the recent bout of equity market turmoil. Until there is some degree of certainty of where policy makers are going, it may be wise to move to the sidelines as the Dollar is likely to face a period of consolidation.