The first three weeks of the month saw risk assets continue to rally, while bond yields declined modestly. There has been a growing dichotomy between the economic outlook discounted by equity markets and the views discounted by fixed income markets so far this year. Equity markets had been posting virtually uninterrupted gains on the back of continued economic growth and an improved earnings outlook, while bond yields in all the major markets had fallen materially due to lower expected inflation suggesting slower monetary policy tightening. Part of the explanation for this divergence lays in the strength of survey data (soft data) and the more restrained picture painted by official data (hard data) such as GDP. Despite the gap between soft and hard data beginning to narrow in a number of economies, bond and equity pricing had reflected biases towards different future outcomes. Then came the speeches by ECB President Draghi and BoE Governor Carney at the ECB conference in Sintra, Portugal. These fuelled market concerns that central banks were beginning to debate potential changes to their reaction functions which would allow them to tighten policy even if inflation remained subdued. The result was a significant rise in European bond yields which spilled over into the US Treasury market and also hurt risk assets.
Inflation continues to disappoint
Inflation has remained sluggish in a number of economies, but the undershoot of inflation in the Eurozone relative to the ECB target has been one of the more pronounced instances. Eurozone inflation has fallen from a high of 1.9% year-on-year in April to 1.4% YoY in May. In part, the weak inflation backdrop is due to base effects as higher oil prices drop out of the annual calculation (with more downwards pressure to come from the recent softness in oil prices) and the continued weakness in wage inflation.
The absence of inflationary pressures from the labour markets has continued to surprise policymakers in the US and Europe, where de-facto full employment (in the US and Germany) would have been expected to lead to more material wage rises than seen currently.
Are central banks mulling a change in their reaction functions?
It has been central bank practice to set inflation targets and ease monetary policy if inflation undershoots the target and to tighten policy if inflation overshoots. Since the financial crisis of 2007-2008, the sluggish performance of most economies has meant inflation has tended to fall short of most central banks’ targets and so policy has been inclined to be – very – accommodative. Where central banks have begun to tighten policy, as in the US, inflation has tended to be close to target, but still below it.
More recently, markets have begun to question the binary relationship between monetary policy and inflation targeting. Doubts have emerged as the US FOMC continues tightening in the face of soft data. A debate has erupted in the ECB governing council about the continued desirability of loose policy given the risks of
creating asset price bubbles. The FOMC is engaged in a similar debate. So are central banks considering a change in the nature of their reaction function, moving towards greater tolerance of an undershoot in inflation? This would mean a central bank would raise policy rates even if inflation was only at around 1% and only pursue aggressive easing if there was a threat of deflation. Recent remarks by Draghi, Carney and several FOMC officials have fuelled market concerns that such a policy shift is seriously being considered.
Such a shift in central bank policy would lead to higher real yields and a reappraisal of risk asset valuations. While we believe there is a lively debate as to whether the nature of reaction functions should be updated and we expect central bankers to become less accommodative than they have been, we feel that we are in the early stages of such a reassessment and the actual shift will not occur just yet.Download to read more