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Central banks, Federal Reserve, inflation, interest rates

Broken hearted by central banks

  • 23Aug 17
  • James Athey Senior Investment Manager, Fixed Income

There are two potential explanations for the recent hawkishness of global central banks.

Key points:

  • Central banks back and forth on policy
  • Old methods may no longer be helpful
  • Globally, policymakers have a hard time forecasting inflation  


The first is that central banks had realized that their policy of monetary easing on a massive scale hasn’t been helping. Instead, it has discouraged investment, encouraged recklessness and driven a further accumulation of credit and mispricing of assets. This has resulted in a large misallocation of resources.

The second possible explanation may be more worrying. This is that the world’s central banks have renewed their faith in the same old broken macroeconomic models that created the global financial crisis, and then papered over the cracks that appeared in its aftermath.

Unfortunately, the second explanation may be correct. Once again, U.S. Federal Reserve (Fed) Chair Janet Yellen may have broken the heart of investors. This time, she did it simply by uttering the words “watching inflation closely.”

Having raised interest rates a couple of times this year despite some near-term softness in inflation, which she previously described as “transitory,” Yellen has presumably been pushed too far by the latest soft inflation figures. Yes, in the 12 months to end-June, the year-on-year consumer price index (CPI) was revealed to have risen by just 1.6%.

Let’s first put aside the fact that the world’s central banks seem to be relatively unable to appropriately forecast inflation. There’s also the fact that many of the prices that make up the CPI are decided in other countries or on global exchanges and are therefore irrelevant to the policy framework. Not to mention, the theoretical models used to justify what can be opinionated assumptions over consumer-inflation indices. We might discover a lack of theoretical or even empirical justification for the relevance of 2%, or the ability of central banks to manage inflation.

Much of the issues we are seeing seem to be related to dogmatism.

Much of the issues we are seeing seem to be related to dogmatism.

The result of the Fed’s renewed concerns about inflation was a rally in U.S. Treasury yields, but also a further decline in the value of the U.S. dollar. With Yellen now seemingly afraid to look beyond tomorrow, and Trump becoming a caricature of his own caricature, the fall of the U.S. dollar has continued. Even when the Reserve Bank of Australia explicitly told investors that they were misreading its minutes and had thus been buying the Aussie dollar under false hopes, the market didn’t seem to care.

Important Information

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

ID: US-220817-41665-1