This was the week financial markets faced up to the realisation that low interest rates and subdued inflation may not be a permanent state of affairs. Around the world, bond investors have taken fright. The 10-year yield on US public debt — perhaps the most fundamental market price in the world — has climbed steeply. Market “break-even” expectations of US inflation over the same horizon rose to 2.2 per cent.
In truth, this is a good news story. The market moves reflect not so much fear or pessimism as the opposite: the expected reflation of a depressed US economy, with spillovers to the rest of the world. That is largely due to the enormous fiscal stimulus planned by the Biden administration, and the Federal Reserve’s determination to keep monetary conditions accommodating. Nominal and real rates are both going up, a healthy reaction to the economy’s faster return to full capacity. The absence of a rise in the dollar — often a sign of greater fearfulness — also shows the optimism at the core of the reflation trade.
Newly higher inflation expectations are no cause for macroeconomic worry. If inflation does indeed average 2.2 per cent annually over the next decade, it will still not make up for the past decade’s shortfall in price growth below the Federal Reserve’s 2 per cent target. The fact that market pricing points to higher inflation in the shorter term — the implied five-year rate is 2.4 per cent — means investors trust the US’s central bankers to keep inflation where they want it. Since the Fed’s update of its monetary policy strategy last summer, its chair Jay Powell has been explicit about treating the 2 per cent goal as an average over time, not an upper limit.
Yet even a much-needed reflation, and the monetary tightening cycle that will rightly accompany it, come with risks. Financiers have become so used to historically low rates that reactions to a higher-rate, higher-inflation regime can be unpredictable. Given how many asset holdings and investment structures are premised on persistently low rates, even small changes could lead to cascades of repricing.
There is no knowing how bond investors will react to a few years of inflation significantly above 2 per cent. Turbulence is likely, and swingeing losses possible. The task for policymakers is to ensure that lossmaking — a normal part of well-functioning capitalism — does not have systemic consequences. That is more a matter of regulation than monetary policy, however.
Apart from investors being caught out, past repricing episodes have exposed problems with the plumbing of financial markets. When asset prices momentarily collapsed at the onset of the pandemic last March, even US Treasury markets briefly struggled to function, and normal trading could only resume after the Fed came to the rescue. A monetary policy tightening cycle, even when it comes as part of a welcome real-economy recovery, could well trigger other nasty surprises. Again, this must be dealt with by market regulators, not interest-rate setters.
The upshot is simple enough. A faster reflation of the US economy would be a very good thing, but vigilance is needed on the way there. Investors must understand their exposures. Regulators must prepare to address mishaps, making sure important institutions are well-capitalised, and map where market dysfunction could be most dramatic.
As for monetary policy, the steady-as-she-goes message Powell gave legislators this week remains right. Indeed, by moderately tightening financing conditions, rising market rates have done some of his job for him.