Markets are betting against central bank guidance as inflation spikes

Summary:

• Imminent half-point rate hikes now predicted for US and UK
• Inflation danger may push officials to slam on the brakes

Global central bankers are urging traders against bets on a supersized policy response to soaring inflation, amid continued hope they can successfully cool mounting price pressures without derailing economic recoveries.

The news Thursday that US inflation exceeded expectations in January, soaring at the fastest pace since the early 1980s, sent investors and economists scrambling to revise their playbooks for the Federal Reserve and fellow central banks.

Financial markets are now betting the Fed will boost its benchmark rate seven times this year, with speculation mounting it will hike by half-a-percentage point in March, in the first such move since 2000. In the UK, traders expect a half point increase by the Bank of England in the next three months, a move not seen since it became independent in 1997.  

Hottest Inflation Since 1982

US headline and core CPI both rose more than forecast in January

Market expectations are now racing ahead of central bank guidance. Karen Ward, chief market strategist for Europe at JPMorgan Asset Management, said the reaction was understandable as traders respond to surging inflation figures.

"Every month the numbers are getting higher. The idea that inflation will go away on its own accord is becoming an increasingly distant prospect," she said. "The tail risk that central banks will have to slam on the brakes is rising."

It's not just traders getting caught up in the idea of aggressive monetary tightening. 

Goldman Sachs Group Inc. economists now see seven US rate increases this year, while their peers at banks including Citigroup Inc., HSBC Holdings Plc and Deutsche Bank AG predict a salvo of 50 basis points will be delivered next month.

Rate-setters hope they can keep inflation in check without suffocating growth, but their stance is fueling criticism from some that they still fail to fully understand the inflation threat.

The BOE and the European Central Bank have both argued that the cost-of-living crisis will squeeze demand out of the economy, hitting growth and risking an inflationary undershoot in the medium term. For the time being, they believe a gradual response will be enough to prevent a damaging wage-price spiral.

Huw Pill, the BOE's chief economist, said his vote for a quarter-point increase in rates this month was intended to demonstrate that the central bank will move in a measured way. 

It was an "investment in containing market expectations of aggressive activism," he said.

The tension between market expectations and the stance of central banks is evident even within the institutions, however. Four members of the BOE's nine-strong rate-setting committee voted for a half-point rise in February. At the Fed, St. Louis President James Bullard said he favors three hikes by July, with one of them being a half-point move.

BOE Outlook

In the UK, markets expect the BOE will crank rates up to 2% from 0.5% in 2022, including a half-point hike before May.

Two rate increases are now priced in this year for the ECB after its president, Christine Lagarde, didn't exclude such a move earlier this month. 

Policy makers have since pushed back publicly against markets. Lagarde herself said a rushed tightening would harm the economy's rebound from the pandemic. 

San Francisco Fed President Mary Daly said Thursday that a 50 basis-point move "is not my preference." Thomas Barkin of the Richmond Fed echoed that view.

Big Move

Markets are betting on a larger than 25-basis-point BOE hike by May

The stand-off suggests a disconnect in communications between markets and policy makers, with one side set to be proven wrong in time. 

Ward, who believes the inflation risk is real but that markets have moved too far, said part of the problem is the difficulty of communicating to "multiple audiences."

"The inflation numbers are eye-wateringly high and central banks are responsible for sorting that out," she said. "When they are talking to politicians and the public they need to sound uber-hawkish, but markets need to know they may not be addressing them. The answer Jay Powell may give to a committee of politicians may not be the same one as he would give to a group of traders."

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.