Inflation Underlines the Dilemma Facing Central Banks

Central bank watchers everywhere seem to be on high alert for any signs of monetary tightening. Investors are parsing bankers’ statements for clues as to when rates will rise. Whether by design or accident, it seems that these central banks are giving off vibes that rates are about to take off. Taking a world tour of central bankers, we note that:

• The Fed has consistently spoken of the need to “normalize “rates, that is to get the real rate of interest into positive territory; in addition, the Fed has signaled that it wants to shed its bloated balance sheet of government and agency debt;

• The European Central Bank ‘s President Mario Draghi delivered a somewhat bullish statement of the EU’s growth prospects, saying that “reflationary pressures” have replaced deflationary ones of the recent past; investors bid up the Euro as talk of tapering of the ECB’s huge balance sheet is being reported widely in the financial press;

• The Bank of Canada’s Governor Poloz stated that the emergency rate cuts issued in response to the collapse of the oil prices “have done their job”; immediately, analysts priced in a higher probability that the bank rate will be boosted at the upcoming meeting in mid-July;

• The Bank of England is struggling with a weakening pound and great uncertainty about the outcome of the Brexit negotiations; yet, some investors detect that the BoE will soon move in the direction of tightening; and,

• The Bank of Japan is facing an unheard of condition of full employment (along with selected labour shortages) with virtually zero inflation, if not outright deflation; none expect the BoJ to change policy in any foreseeable future.

Bond markets in Europe and North America sensed that there may be a systematic shift in monetary policy towards raising rates. The 10 year bond term rates moved up about 15 bps in North America and both Gilts and the Bunds moved up smartly at the same time.The currency markets took their cues from the central bankers the past week as the Euro and Canadian dollar gained at the expense of the US dollar.

There is one fly in the ointment: inflation is no where to be found.

In fact, the major industrialized countries are further from reaching their target of 2% inflation than anytime in the last couple of years. Compared to the previous month, the annualized inflation rate in the Eurozone sank to 1.3% from 1.4% ; in the U.S. inflation rate dropped from 1.7% to 1.4% ; and Canada’s inflation rate dropped from 1.6% to 1.3% . So, it appears that the inflation target of 2% is becoming more elusive. The problem of weakening inflation will become more acute in the coming months, given the fall in energy prices of late.

So, what is motivating the central banks to warn of higher interest rates? Could it be that they want to discourage further risk taking in various asset classes? Or, could it be that they want to “normalize” rates to those prevailing pre-2008? No clear motivation has yet to be given.

The Canadian situation is typical of the risks a central bank run in pursuit of systematic tightening. Crude oil prices are in the low $40s and are trending down. Higher interest rates and the accompanying higher Canadian dollar will harm its oil exports. The housing market is vulnerable to higher borrowing costs and household debt levels are at all time high. So the Bank of Canada needs to approach monetary policy very gingerly for fear of harming this nascent recovery. Any increase in the value of the Canadian dollar comes at great expense to its manufacturing exports, a sector that continues to face headwinds from protection policies originating in the United States. If it does raise rates, it would be very harmful to the economy and would likely send inflation even lower. Despite the overall improvement in the Canadian economy, the challenges to the Bank of Canada have not changed that much.

Larry Summers, former US Secretary of Treasurer, cautions the Fed not to fire (raise rates) until they see the “whites of their eyes “( inflation) . We are still watching the enemy, but have not seen the whites of their eyes.