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Investors are skeptical central banks can meet their inflation targets.
Investors are skeptical central banks can meet their inflation targets.

CBs Fiscal Policies to Stay

Inflation expectations as seen in the markets for bonds and derivatives are becoming increasingly volatile

CBs Fiscal Policies to Stay

This is a busy time for major central banks. The Bank of Japan and European Central Bank met last week, the Reserve Bank of Australia and the Federal Reserve meet this week, and the Bank of England meets next week.
Although most major central banks are deciding not to make big changes to monetary policies, global interest-rate expectations among investors have shifted to a tightening bias driven almost entirely by the anticipation of expansionary fiscal policy. The reality is that central bank policy on average is likely to stay looser than generally assumed by markets, Bloomberg reported.
To understand why, you need to first consider the stark divergence between economic data that is based on sentiment and data that is based on actual activity. The sentiment-based, or “soft”, data has consistently surprised to the upside, creating a strong correlation with higher interest-rate expectations. The actual, or “hard”, data such as measures of gross domestic product or factory production has been relatively weak. This divergence may drive central bank policy expectations in opposite directions with consequences for different markets.
One consequence is that inflation expectations as seen in the markets for bonds and derivatives are becoming increasingly volatile. Respondents to surveys suggest that they see faster inflation and some central banks, such as the European Central Bank and Bank of Japan, say they need to take a cautionary stance when it comes to inflation.
But despite an uptick in actual inflation data, market based long-term inflation expectations suggest investors are skeptical central banks can meet their inflation targets. This difference isn’t likely to go away anytime soon, forcing central banks to maintain a bias toward tighter policies even if they don’t tighten.  
Financial Conditions Tightening
Also, financial conditions have begun to tighten in some critical places around the world as a result of geopolitical tensions on the Korean peninsula, election uncertainty in Europe, and challenges to US domestic fiscal policy. The ability to tighten monetary policy based on financial conditions can really only be seen in the US, whereas those in Europe and Asia are too tight to remove policy accommodation.
The divergence in financial conditions can be a boon to equities and credit—high yield in particular—as investors continue to seek higher returns in a world of zero or even negative interest rates. Even a gradual adjustment higher in the US federal funds rate is not likely to derail the positive run in equity markets as global financial conditions remain loose.
But a report on Monday by Fox Business says, Federal Reserve officials are likely to keep interest rates steady at their policy meeting this week and drill down into details about when and how to reduce their large holdings of mortgage and treasury securities. The two-day policy meeting begins Tuesday.

Capital Flows
Then there is capital flows into emerging markets, where some central banks are easing, such as Russia and Brazil, and others are tightening, such as Mexico, Turkey and China. The diverging policies among emerging-market central banks are visible in real interest rates. The gap between emerging and developed market real rates has become the widest in more than five years.
That can continue to put upward pressure on emerging-market currencies, bonds and equities, bolstering growth in places such as Brazil that suffered significant economic contraction in recent years. So, divergences in inflation expectations, financial conditions and real interest rates will continue to shape global central bank policy.
For markets, that means the Japanese yen comes under pressure as a global funding currency for carry trades, interest rates stay negative in Europe, asset prices get pushed higher, and allows the Federal Reserve to continue to tighten. Central bank divergence is now driven by differences between sentiment and actual data. Until those two data sets converge, global central bank policy is likely to stay looser for longer.

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