Central banks’ contest with the markets

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The Federal Reserve’s press conference this week should have been a time for chair Jay Powell to bask in the newly upgraded forecasts for US economic growth. The Fed now thinks the economy will expand at 6.5 per cent this year. It expects to overshoot the 2 per cent inflation target and gradually converge to it from above.

But that left Powell in the awkward position of explaining why, given how much better things look than just a few months ago, the Fed is not tightening its signalled path for monetary policy. There are perfectly respectable answers, which Powell gave. Policymakers learnt from the last crisis that it is damaging to withdraw stimulus too soon; inflation is less sensitive to demand pressure than once feared; the Fed has changed its strategy to being more tolerant of growth until full employment is reached and average inflation has caught up with past shortfalls.

Yet market participants do not quite believe him, and are clearly minded to test the Fed’s resolve to keep monetary policy loose. Bond yields keep rising. In past stand-offs where markets disagreed with the Fed’s expectation of rate rises, it ended with the central bank backing down. This time speculators are taking the inverse bet: that the Fed cannot stay loose as long as it wants.

At some point, the Fed may have to adjust policy to discourage market movements it does not like. For now Powell is asking markets to believe that the Fed will be patient. He can afford to treat their bets with benign neglect; the rise in yields is not excessive in light of the rapid improvement in economic prospects. The Bank of England, too, stayed its course this week. Sensibly enough, it saw a modest rise in rates as a natural reaction to good news, in particular the UK’s successful vaccine rollout.

Even so, the policy dilemma of markets front-running the economy is sharpening. Other banks are facing it too.

In the eurozone, rising market rates look more premature than across the Atlantic. In response, the European Central Bank plans to accelerate bond purchases amid strong hints it wants broad financial conditions, which include long-term market yields, to be as loose as they were in December.

The Bank of Japan and the Reserve Bank of Australia’s policy of “yield curve control” means they manage longer-term benchmark rates outright. But even they have had to buttress their defences. The RBA faced a speculative attack by short-sellers doubting its willingness to defend its 3-year yield target in a world of falling bond prices, prompting its governor to commit to buying more bonds as necessary.

The BoJ’s monetary policy review, published on Friday, addresses the same challenge: how to maintain credibility in the face of uncertainty that is rising, albeit for welcome reasons. Its review slightly widens its tolerance band for long-term bond yields around its target and lessens its commitment to buying equities. These moves may seem to accommodate market pressures for higher rates. But the BoJ also boosted its reserve tiering system for banks, communicating explicitly that concerns for bank profitability and stability would not stop it from cutting the already-negative policy rate further if needed.

What is common to all these cases is that markets anticipate rate rises, thereby bringing them about before policymakers think it is right. Years of acute crisis, like 2008 or 2020, might reasonably be considered the worst time to be a central banker. In fact, the most challenging moment can be as recovery begins. This week’s stand-off between markets and policymakers certainly suggests that the hours before dawn are the darkest.

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