Inflation – Central banks forward guidance

Inflation – Central banks forward guidance

Inflation is moving on the radar again and the central banks forward guidance could be the smart tool to combat it.

Whether it be buying groceries at the supermarket, topping your tank at the gas station or purchasing back to school items for the kids buying more for less is becoming challenging. Inflation is beginning to stretch household budgets. Even the (messaged) macro data is flagging rising inflation for many advanced economies.

For example, in the UK, the GBP consumer price index, which measures change in the consumer price index (CPI), including food and gas (also known as inflation) is on a steady trajectory upwards at 2.9% (YoY AUG) which was above the market forecast of 2.8% for the same period.

In the Euro bloc, annual inflation is also is expected to be 1.5% in August 2017, up from 1.3 % in July 2017, according to Eurostat.

Moreover, across the pond, US inflation accelerated in August amid a jump in the cost of gasoline and rents. US CPI rose 0.4 percent last month after edging up 0.1 percent in July. US consumer prices accelerate in August.

So inflation is on the up in the UK, the EU, and the US. But it is not due to a buoyant economy. Consumer spending remains weak, wage growth is virtually nonexistent and business investments are also anemic.

The crashing Vice Index (which is being under-reported in the mainstream) supports the view that inflation is rising and it is not due to robust consumer demand which typifies a buoyant economy.

Vice Index is the cashed based economy nonessential (vices) goods and services, in other words, gambling, drugs alcohol, and prostitution.

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The Vice Index is sensitive to a slowdown because these are nonessential items. They make up discretionary spending. Moreover, most of these services tend to be bought with cash, not credit.

So when money is tight the Vice Index is the first to crash and that could give investors, traders a heads up on future consumption and the direction of the economy.

In short, the data (conventional and nonconventional) indicates that the economy could be entering a period of stagflation which is characterized by high inflation, slow economic growth, and high unemployment. Perhaps a painful period of the 1970s stagflation could be dead ahead.

But cooling off cost-push inflation (due to currency devaluation) which is what the UK is experiencing with steady rate rises could stifle economic activity and drag the economy into a deep recession.

This is where the central banks forward guidance could be its smart tool in the central bank’s monetary policy toolkit.

Indeed, last time the Fed experimented with forwarding guidance as a policy tool (instrument) was with its well-known Four Dot Plot Plan in 2016. To some extent it was successful, forward guidance kept the market pricing expectations of a rate rise (even though the Fed hiked rates only once in 2016 by a quarter point to between 0.50% and 0.75%).

That kept USD strong, precious metals down and equities in check. In other words, the central banks forward guidance kept cost-push inflation under control.

Keep in mind that if USD crashes input prices go up. The world’s most valuable commodities from crude oil to iron ore, copper and wheat are all priced in USD. If USD falls in value producers will recover their losses by putting up prices. So there tends to be an inverse relationship between USD and commodity prices. A declining USD means rising commodity prices (inflation) and vice-versa.

So the central banks forward guidance is likely to be relied on to tackle rising inflation and a slowing economy. Indeed, last week we saw a complete turnaround in sentiment at the BoE, where Carney’s Monetary Policy Committee (MPC) put a 25bp rate hike firmly on the table. Their rationale was to curb the rise in inflation and “tightening of economic slack” which all justifies an adjustment in interest rates. The BoE’s MPC reckons that the market has under-priced the probability of a rate hike in their forecast horizon and last week let the market know that they are pretty much committed to a move.GBP took off.

Additionally, the Fed is preparing the market first, for a rate hike, although we are close to 50/50 again.

The central banks forward guidance is already being used by the BoE which has proven to be effective in setting a market expectation for a rate hike and thereby making the transition to monetary policy normalization less volatile on financial asset prices.

Forward guidance could very well be the central bank’s smart tool.
Why?

When markets get a whiff of a rate hike from a more hawkish sounding monetary committee that will halt the relentless depreciation of its currency (the desired impact). But monetary tightening also makes existing loans more expensive for businesses and households to service. Put another way, a rate hike acts as a drag on the economy, it slows the economy down. This could be a potentially adverse impact, particularly when the economy is experiencing sluggish growth.

So forward guidance (setting the market expectations) is the central bank’s medicine with outside effects. The central banks can engineer the impact of a rate hike in asset prices through forward guidance with no (or minimal) adverse impact on the economy.

Factoring in the inflationary trade in your portfolio could be prudent, in other words profiting from price rises by investing in commodities.

But here is the takeaway, don’t underestimate the central bank’s ability through monetary policy to push the market around. In the past, so many investors were caught out by the central bank’s quantitative easing to keep markets buoyant. In future, so many more investors could be caught out again by forward guidance.

At some point, and we are approaching it soon, the central banks will starting hiking rates-they will need to, otherwise, they risk turning forward guidance into a blunt instrument and equally lose face with investors. But that could also make the inflation trade less profitable too.