Commentary on Political Economy

Monday, 21 December 2020


Only a few days ago, we warned that central banks are not on the edge of a precipice... THEY ARE SLEEPWALKING ON A KNIFE-EDGE! That means that their policies now rely absurdly on communication, on the words they use, to keep markets calm, because they have run out of 'instruments'!

Central banks to walk tightrope on communication in 2021

Christine Lagarde speaks during a live stream video of the European Central Bank’s news conference in October © Bloomberg

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Investors hope that for policymakers, 2021 will be the year of speaking carefully.

Central banks and governments rode to the rescue of markets in 2020, blasting the financial system with cheap cash, liquidity and promises of long-term support on a huge scale. Fund managers were not always the direct target of that support, of course, but the effect is the same. The global financial system peered over the brink in March, and swiftly retreated.

One of the main reasons why the injections of monetary and fiscal support were so successful in hauling risky assets up from the depths of despair was that they were effectively unlimited.

On the monetary side, the message, from the US Federal Reserve, the European Central Bank, the Bank of England and others was: do not doubt our resolve. Clearly, deep interest rates cannot cure victims of a virus. Nor can vast bond-buying programmes, furlough schemes or an alphabet soup of measures to keep businesses alive through the shock of coronavirus. 

But there were assurances that the support is there for as long as it is needed, that rates will stay nailed to the floor even if inflation picks up, and that forms of assistance are limited only by the confines of policymakers' apparently boundless imagination. That was an important moment in convincing investors to pinch their nose, ignore an economic collapse barely matched in peace time, and buy risky assets.

The question now is how policymakers stick to that commitment to keep the taps running.

The key here, to global investors at least, is the Fed. It has been very clear, under a policy announced in August that it will allow inflation to run hot, to make up for the times it has frozen up the pipes in the past few years, before raising interest rates. And only last week it said it would keep buying at least $120bn of debt per month until “substantial further progress has been made” in the recovery,

But fund managers know it is one thing to forge a policy like this and another to stick to it in the unlikely event that inflation does indeed rapidly exceed the 2 per cent target.

Fiscal and monetary support are keeping economies afloat but only just.

Vincent Mortier, Amundi

“I don't think central banks will have to look through inflation, because I don't think there will be any,” says Valentijn van Nieuwenhuijzen, chief investment officer at Dutch asset manager NN Investment Partners. 

Nonetheless, it is a risk worth taking seriously, and one that could prompt central bankers to blink, to send out a hint that support will not last for ever. Those who remember the firestorm in markets in 2013, when then Fed chair Ben Bernanke made similar comments about pulling back post-2008 quantitative easing, know that it can be quite a ride.

Premature rate rises, as soon as next year, are not so much a tail risk as an outlandish prophecy. Just implausible. But a stumble in language is not.

“You need to distinguish between a policy error and a communications error or even a change in tone,” Mr van Nieuwenhuijzen says. “That could give an excess impact in the market.”

Slip-ups do happen. Recall that in March, ECB president Christine Lagarde sparked a violent reaction in Italian government bonds when she said that it was “not the ECB's job” to try and eliminate the gap in bond yields between shakier and safer eurozone states. Clearly, the market thought it was, and punished Italian debt. Ms Lagarde swiftly apologised for her error and has since won back market trust.

Chances are, central bankers will remember the market ructions of Mr Bernanke’s so-called taper tantrum well enough to avoid taking this route again. They will be careful with their comments. “They have learnt from their errors,” says James Athey, an investment manager at Aberdeen Standard Investments. The same might not be true on the fiscal side.

Already, UK chancellor Rishi Sunak has spoken of “hard choices” and a “sacred duty” to strong public finances — comments some investors see as laying the groundwork for the A-word: austerity. Meanwhile, unless the Democrats succeed in snapping up the two US Senate seats up for grabs in January’s run-off vote in Georgia, then Joe Biden's White House will find itself butting up against a split Congress. That could easily limit the scope of support from government coffers for a US economy.

“Fiscal and monetary support are keeping economies afloat but only just,” says Vincent Mortier, deputy chief investment officer at Amundi. “Any withdrawal of measures is unthinkable right now, and the risk of a policy mistake is underestimated by the market.”

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