After making forward guidance (to steer medium-term expectations about interest rates) their main instrument of monetary policy, both the Fed and the Bank of England (BoE) appear to more inclined to restore some degree of symmetry to market operators’ expectations. During the July Humphrey-Hawkins testimony, given twice yearly, before Committees from both Houses of Congress, Fed Chair Janet Yellen made it quite clear that the direction of interest rates might well be influenced by what happened in the next few months. “If the labor market continues to improve more quickly than anticipated by the Committee (Federal Market Open Committee), resulting in faster convergence toward our dual objectives, then increases in the Federal funds rate target likely would occur sooner and be more rapid than currently envisioned. Conversely, if economic performance is disappointing, then the future path of interest rates likely would bemore accommodative than currently anticipated”.
These seemingly anodyne, even tautological, remarks reflect the reality that the US economy is at a crossroads. Recent developments on the inflation front, despite being heavily swayed by food prices and an extremely taut rented housingmarket, do nonetheless imply some erosion of US consumers’ purchasing power. The missing link in what would be a classic inflation cycle is still evidence of higher prices filtering through into wages growth. So, either that will start to kick in over the next few months, helping to restore some of households’ purchasing muscle, or, if it fails to spark pay increases, then consumer spending (70% of US GDP) will be dented, which, by extension, will cast a cloud over the economy’s overall growth prospects.The Fed’s response to these two scenarios will be diametrically opposite.
Although the UK economy has been comfortably beating expectations for several quarters in a row now, it too faces the pretty much the challenge as the US economy. UK unemployment may well have plunged from 8.4% in November 2011 to 6.5% at present, but wages growth is still very pedestrian. In a recent speech entitled “Winning the economic marathon”, BoE Governor Mark Carney made the following comments: “While some indicators such as wages suggest that there was more labour supply than we had previously thought, it is also true that spare capacity is being used up a bit more rapidly than we had expected”. Once again, this twin-edged remark suggests that, like its US counterpart, the UK economy is entering tricky waters for a central bank: on one side, the rocks of longlasting stagnation and, on the other, the maelstrom of accelerating inflationary growth make navigating the right monetary-policy course that much more of a challenge.
After reacting in rather confused fashion to the ECB’s announcements on 5 June, inflation break-evens in the eurozone moved up by around 10 basis points across the board of maturities in July, matched by real rates drifting down 10 to 20 basis points. The prospect of more liquidity being pumped in via the two Targeted Long-Term Refinancing Operations (TLTROs) in September and December was not enough to explain this recent trend. Even if the two TLTROs are a resounding success, the net maximum amount to be allocated would be EUR400bn, i.e. roughly the same (EUR375bn) as the amounts still outstanding in the end-2011 and early-2012 Very-Long-Term Refinancing Operations of which run their course between end-2014 and early 2015. This means that, at best, we are only really like to see these TLTROs being tantamount to an extension of the maturity on existing liquidity rather than a genuine increase. Renewed interest in inflation-linked bonds has, doubtless, been rekindled by the perception these measures will just not be enough, implying the ECB will have to turn to its weapon of last resort: a larger-scale round of quantitative easing.
Continue reading: Pictet Monthly Bond Letter - August 2014
