Several of the major central banks in the world appear to have suddenly shifted to a hawkish bias from a dovish one, led by the U.S. Federal Reserve. Fed Chair Janet Yellen, whose career has mostly had a dovish tone, is set to deliver testimony on Wednesday and Thursday, and economists will be looking for further confirmation of the apparent policy shift.
Economists see Wednesday as being the most important day this week, between Yellen’s testimony and the expected interest rate increase by the Bank of Canada, which hasn’t raised rates in nearly seven years.
In a recent report, Bank of America Merrill Lynch economists Ethan S. Harris and Aditya Bhave noted the growing number of central banks that are adopting a more hawkish bias from the risk-averse mindset they previously had. Last year, the Fed signaled a slow pace of steady interest rate increases but then postponed those increases at the slightest glimpse of stress in the market or economy.
The European Central Bank also remained risk-averse last year as it boosted its monthly buying to €80 billion in March 2016. The Bank of England hesitated ahead of Brexit and then suddenly adopted a hawkish bias in response to the vote to leave the European Union, which contributed to the pound's double-digit collapse, the BAML team added. Meanwhile, China zeroed in on the turmoil in the market, while Japan finally seemed to shift to a "consistently easy monetary and fiscal policy," they added.
Hawkish despite weaker growth
Now with Donald Trump in the White House, the Fed seems determined to forge ahead with an aggressive stance even though growth and inflation are both weaker, they explained. The Fed hiked interest rates at multiple consecutive meetings and continued to signal more interest rate hikes for this year. The U.S. central bank also laid out "a seemingly predetermined path of balance sheet shrinkage," they added.
But the hawkish bias isn't just limited to the U.S. where Trump is in power. The BAML team noted that the ECB's asset buying program is struggling against apparent political constraints and now is on track for a "predetermined tapering track." The BOE has also turned hawkish as three members argued for immediate interest rate increases because they expect healthy growth and high inflation.
A free pass for the hawkish Fed
Harris and Bhave aren't too concerned about risk for now, as they said the markets seem to have "given the Fed a free pass." They note that risk assets remain strong and the bond market isn't pricing in much of a rate hike. Further, the markets simply aren't taking the Fed's sudden hawkish bias seriously because they don't think it will make good on what it has said it will do.
"If this 'Goldilocks' scenario cools or if the data continue to disappoint, the Fed can reverse course if it wants to," the economists explained.
They also note that the BOE followed up its similar hawkish bias in 2011 with another round of quantitative easing not much later.
Can the Fed hit its inflation target?
The BAML team also pointed out that the Fed has been struggling to hit its inflation target, and other major central banks seem to be giving up on achieving their inflation goals too. They don't believe Yellen will acknowledge that the Fed has been struggling to hit its inflation target, or that expectations for inflation have fallen and there's a significant risk of overshooting.
Today Caroline Baum raised the same issue in a post for MarketWatch. The Fed set its inflation target at 2% in 2012, and only once between April 2012 and now has the personal consumption expenditures price index broken through a 2% year over year growth rate. Baum also pointed to the main explanations the Fed has attached to its "chronic undershoot" of its inflation target. The U.S. central bank has blamed its misses on everything from oil prices—a years-long excuse—to prescription drugs and wireless-telephone services.
She feels that policymakers are "running out of excuses to explain their failure to hit their inflation target."
"That's what happens when you adopt a target without formulating a strategy for hitting it," she wrote. "And harping on the half-point miss implies that the Fed has it in its power to fine-tune the inflation rate to the nearest tenth of a percentage point!"