Weekly Update - Why it matters that debt markets get monetary policy right
Leading central banks go into a round of crunch meetings in mid-December, rounding off a historic year for policy tightening. Bond markets are a key lever for transmitting monetary policy to the real economy and the big fluctuations of recent weeks have complicated the situation.Historic tightening of monetary policy. 2022 will be remembered for a radical policy shift by central banks to cope with a succession of serial inflation shocks: the Federal Reserve (Fed) hiked rates by 400 bp, the Bank of England (BoE) by 300 bp and the European Central Bank (ECB) by 200 bp. All three also tweaked their balance sheet policies: the Fed and BoE both began quantitative tightening, slimming down their balance sheets by either selling off securities or not reinvesting proceeds as they mature, while the ECB halted its asset purchase programmes and encouraged banks to early redeem TLTRO borrowings. True, inflation may well now have peaked on both shores of the Atlantic, but underlying pressures persist and will continue to make monetary policy forecasting an uncertain business in 2023.
The importance of market expectations. Debt markets are a major channel for transmitting monetary policy. They translate movements in central bank policy rates into the interest rates demanded at different maturities and between different counterparties (governments, financial intermediaries, companies). In this way they help turn tighter monetary policy into more expensive financing terms for consumers and businesses in the real economy. This squeezes demand (consumption and investment) and so eases pressure on inflation. However, debt markets base their movements on expectations for monetary policy and growth, and if their expectations go wrong so does the transmission of monetary policy. For monetary policy to work properly, debt markets have to price in the right levels of current and future policy tightening. And for some weeks now, market forecasts have been up and down like a yo-yo based on the latest inflation and economic news. As it stands, markets still expect the screws to keep tightening into early 2023, but have heavily scaled back their forecasts for central bank rates in the medium term. This substantially more dovish outlook has left real rates - stripped of expected inflation - once again converging towards zero, which means the current rate tightening will have less of a real world impact. Raising the risk that central banks will have to push rates higher and harder to bend the economy to their will.
What will December meetings bring? The mid-December meetings by central banks (Fed on the 14th and ECB and BoE on the 15th) will be crucial in getting the message through to debt markets. At the moment, it looks highly likely the three banks will hike rates by 50 bp apiece. Any messaging on terminal target rates or tightening of balance sheet policies could force bond markets to sharply revise their forecasts, in the direction central banks intend.
Finally, in the main events of the week, we have chosen to talk about the fluctuations in the price of Brent oil as well as the easing of sanitary constraints in China.