Central Banks have hit a moment of truth – Deutsche Bank

Central Banks are struggling to create consumer goods and services inflation, but they remain remarkably adept at creating asset inflation, feels Alan Ruskin, Macro Strategist at Deutsche Bank. How Central Banks will respond to the increasing evidence that their output gap frameworks for goods inflation forecasting appear to be failing badly, while asset inflation sometimes points to excess policy stimulus will be a key question going forward, he further adds.

Key Quotes

“Policy focused solely on consumer inflation can be terribly misleading as a target that secures an optimal growth path.  If we want evidence of this, let us not forget that US core inflation was tracking in the highly desired 2%  – 2.5% range for the 4 years running up to mid-2008; and we all know what happened next.”

“Policy advice on how to move forward is contradictory with prescriptions as far removed as inflation targets should be lower; to inflation targets should be raised to achieve a desired price level path over the cycle; to more drastic proposals to completely refashion the framework and take a more holistic view of inflation that includes asset inflation.”

“More recently there have been a few and mixed signs from the Fed and BoC that they are becoming more willing to look beyond flat Phillips curves, and place some policy weight on ebullient financial cycles.”

“A full 8 years into the recovery from the Great Financial crisis, there is also some belated recognition that emergency policies are no longer warranted!”

“The removal of emergency measures is another way of talking about a shift to ‘rate normalisation’.  Divisions are emerging within Central Banks, and across Central Banks, among those emphasizing ‘normalisation’, and those that favour a more doctrinaire adherence to inflation targets and mandates.”

“For the Fed, another two 25bp in hikes would take the real funds rate close to zero and into a range where ‘normalisation’ will become less compelling, assuming the next Fed Chair does not change the current framework.”

“The ECB may be a few years behind the Fed when it comes to closing unemployment gaps, but the policy debate is already getting pulled in two directions as hawks ask whether extreme emergency policies are still warranted, and traditionalists focus on contained HICP.”

“Global consumer disinflationary forces should not be regarded as risk negative.  On the contrary, it is not unusual for goods inflation and asset inflation to be negatively correlated for long periods as they were for much of the 1980s and 1990s.  The causal chain from low goods inflation to easy policy to favorable risk appetite has yet to be broken.  Central Banks will generally remain slow to take away ‘the punch bowl’.”

“Ironically low consumer inflation could contribute to well behaved bond markets that will make a retreat from emergency short-term rates easier to enact, without slowing growth.”

“There is unusual capacity for disagreements within Central Banks, and differentiation across Central Banks, as the inflation targeting debate and the exit from emergency measures heats up. Market sensitivity to individual policymaker statements is on the rise, and the clarity of the policy messages has already begun to suffer. The decline in ‘signal to noise’ will continue to add to short-term rates vol and FX gamma.”

“For a given goods inflation rate, the most recent shifts tends to slightly favor a more hawkish policy approach, consistent with a more mature global recovery.”