This is an interesting and informative article by Martin Enlund, Chief Analyst Global Research at Nordea Markets. He argues persuasively that market participants should focus on changes in inflation expectations which derive from the drop in oil prices. If those inflation expectations shift that will drive changes in monetary policy. It is a worthwhile read.
Via Martin Enlund at Nordea Markets:
Global: Oil prices strain (some) central banks’ credibility
Martin Enlund |
A supply-driven drop in oil prices is net-positive for medium-term inflation outlook. But this matters little for central banks whose credibility is being challenged. Instead, it rather increases the risks for already-challenged central banks (e.g. ECB). The FX theme of monetary policy divergence will remain on track. Inflation expectations will remain crucial in the Euro Area and are rising in importance in the US.
A supply-driven drop in oil prices can be seen as net-positive for medium-term inflation outlook. But this matters little for central banks whose credibility is being challenged. Instead, it rather increases the risks for already-challenged central banks (e.g. ECB).
Central banks such as the ECB are alarmed about the second-round effects from inflation being too low for too long. If inflation expectations are allowed to decouple from respective targets, central banks lose control over the medium-term inflation outlook (for instance as wage growth gets cemented at “too low” levels). This is important to bear in mind when considering the FX effects from what’s going on with oil prices. A supply-driven drop in oil prices is good for purchasing power, good for growth, and actually net-positive for the medium-term inflation outlook (as output gaps close quicker), but this matters only if inflation expectations remain well-anchored.
Central banks thus focus intensely on inflation expectations. For instance, ECB’s Draghi has argued that “[o]ur ultimate test is inflation expectations and that we are going to gear our action according to how the medium-term outlook of our inflation expectations will develop in the coming months, not coming years”. As the period of “lower-for-longer” in inflation terms is further prolonged, the downside risks to medium-term inflation expectations is rising, as will be the distress among certain central banks (especially the ECB). Since ECB Draghi’s speech in Jackson Hole, EUR/USD is negatively correlated with inflation expectations (chart 1), counter to its long-term relationship. While this would suggest the EUR would climb on lower oil prices, it is rather a sign that the market has traded both EUR and break-evens on “ECB credibility”. This makes sense since it is the ECB, and not the Fed, who has a credibility problem. For more on this, see Global: the war on inflation expectations.
HICPxt fixings are now seeing deflation risks already in Q1 next year (deflation defined in negative HICP inflation rates, chart 2). Indeed, EUR inflation swaps have never assessed deflation risks as high as they are today, see EUR inflation (part 2): Deflation fears are real.
Turning to the US, Fed 5y5y break-even inflation rates have been below levels consistent with the Fed’s 2% PCE inflation target since late September, and the Fed has played down most of the disinflationary trends recently, instead sending a message to markets that it just doesn’t care that much – at least not now. Why is this? The Fed has (arguably) got three mandates: price stability (which is now being a bit challenged by the inflation market – but only a bit), maximum employment (remains on track to be met next year), and “moderate long-term interest rates” (this should worry the Fed – the term premium is as depressed today as in the months ahead of Bernanke’s taper talk). Two out of three mandates thus suggest the Fed will remain on its track towards exit, while the price stability mandate is a bit challenging.
Looking ahead, recent oil price developments may trigger substantial drops in US inflation rates very soon (chart 3). This could prompt speculation of later (or fewer) Fed rate hikes. The Fed’s mandates do however suggest it still got decent reasons to remain on track towards further policy normalisation.
The market may thus remain fairly confused by Fed policy, just as it has been since the middle of September. Household’s and forecasters medium-term inflation expectations will be crucial to watch – if they start to show “unanchoring”, that could potentially prompt a substantial switch in Fed policy. Fed Dudley, of the informal Fed Troika, has after all hinted that he is focusing much more on survey inflation expectations, than what’s going on in the bond market.
In short, global energy price developments increase the credibility risks for the already-challenged central banks. The FX theme of monetary policy divergence remains on track however.