European central banks seem ready to join the Federal Reserve on a cycle of tighter monetary policy. But their actions may have more to do with the misguided attempt to throw “shock and awe” at inflation expectations than a true commitment to higher interest rates.
On Thursday, the Bank of England raised rates for the second time in a row, bringing them to 0.5%. Shortly after, European Central Bank President Christine Lagarde opened the door to nudging up borrowing costs later this year. Derivatives contracts, which were already suggesting one rate raise by the ECB in 2022, have started pricing in two of them. The euro has gained more than 1% against the U.S. dollar, and 10-year German government-bond yields jumped from zero to almost 0.2% Friday. U.K. markets have been a bit more restrained.
Investors already knew that the BOE intended to tighten policy aggressively. The real shock came from the ECB, which was one of the few holdouts until eurozone inflation surprisingly hit an all-time high in January.
“The situation has indeed changed,” Ms. Lagarde said. “We do refer to the upside risk to inflation in our projection.” She also provided hints that a more concrete shift could happen when the ECB updates its economic forecasts in March.
Many investors are understandably tempted to jump into the “synchronized central-bank tightening” trade—that is, selling stocks, European bonds and the U.S. dollar in favor of euros and pounds. They shouldn’t get carried away.
Yes, some ECB members favor tighter policy, but such rhetoric has been heard before and rates in the eurozone still haven’t risen in 11 years. Ms. Lagarde said they won’t go up until the bond buying stops, and this is likely to take a few months even if announced in March. By then, favorable year-over-year comparisons will probably start to push down inflation. Could the ECB lift rates once to undo pandemic-era easing? Sure, but the Fed has room to do it five times during the same period.
In Britain, four out of nine rate-setters voted for even tighter policy, and Bank of England Gov. Andrew Bailey even went on the BBC, the U.K.’s public broadcaster, to ask workers not to demand big pay increases. Yet, after Thursday’s policy meeting he also said that the tightening is meant to be front loaded, and suggested that the market’s longer-term rate expectations are excessive. Currently, derivatives price them at 1.7% in a year’s time.
It very much looks like European central bankers’ main objective this week has been to send a message to consumers and firms to avoid higher inflation expectations from becoming “entrenched.” According to the orthodox policy handbook, this will prevent actual inflation from becoming self-sustaining.
There are reasons to doubt inflation expectations matter so much. Households’ actions are much more dependent on their financial situation and position of power over employers. Eurozone wage growth remains subdued and the Omicron variant of Covid-19 is already causing damage, business surveys suggest. Meanwhile, retail sales in the U.K. have looked really tepid of late, and consumers are facing a huge rise in energy bills in April that the latest government policies will fail to offset. These hardly look like demand-overflowing economies that will allow central banks to keep pushing borrowing costs above pre-pandemic levels. By contrast, the U.S. reported stellar labor-market data Friday.
Despite the dollar having already appreciated a lot recently, those betting on central-bank divergence may want to keep their cool and carry on.
Write to Jon Sindreu at [email protected]
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