Dhara Ranasinghe & Sujata Ro

LONDON (Reuters) – For markets trying to navigate the pathway for stickier-than-expected inflation, a move to asymmetric price targets at the world’s two biggest central banks may be a recipe for wild and increasingly frequent bond price swings.

In 2020, the U.S. Federal Reserve established a flexible average inflation target (FAIT), which was designed to allow for price pressures. This is a significant shift in Fed’s dual approach toward stabilizing prices and maximum employment.

Following this, the European Central Bank set a 2% medium term inflation target. It also abandoned its “below but near to 2%” policy.

They both consider current price pressures “transitory,” but are now facing the real test for these new frameworks.

Lyn Graham Taylor (Rabobank senior rates strategist) said, “Hindsight can be a beautiful thing but it is unfortunate timing we had those reviews.” “Under old mandates we had a good understanding of the central bank’s reaction function. There’s now more uncertainty.

It is difficult to predict how hot central banks will allow inflation to run.

The annual inflation rate in the Eurozone is higher than 4%. However, it’s likely that the U.S. consumer prices index exceeded 5% last month due to supply shortages and hot commodity prices.

(GRAPIC:Where next for inflation?-https://fingfx.thomsonreuters.com/gfx/mkt/zdvxonnjxpx/USEZinflation0911.PNG)

Although central banks are unable to control these factors, they can often intervene early in order for consumers to not expect future inflation and pay significantly more.

New Zealand and Norway both have raised their rates. Canada and Britain are also on the verge of doing so. The Fed will unwind $120 billion of monthly stimulus but it does not intend to increase rates.

The ECB is not likely to make a decision for several years.

However, markets tend to be wary of unexpected hawkish developments.

David Arnaud (senior fund manager, Canada Life Asset Management) believes that the asymmetric target raises more questions than it answers about central banks’ policy response.

He stated that “they’re saying they’re going make up for previous low inflation by allowing inflation run hotter than 2% so on average, we’re going going to be in a position to reach our 2% goal.”

“But how long can you allow inflation to run over your target?” What is an acceptable level of inflation? They didn’t intend to define these metrics, as they wanted to leave their options open. However, this created uncertainty, making it difficult for bond investors to understand the reaction function.

HARD TIMES

One of the instruments central banks employ to send policy messages is sovereign bonds. Investors may be confused if they don’t get the message.

This is what happened when bond yields soared in anticipation of central banks attempting to combat inflation. However, they plummeted after policymakers ended their bets.

The 10-year Italian yields increased from an 18-basis-point jump weekly to a fall of 25 bps each week. Even staid Germany experienced a 19-basis-point drop in 10-year borrowing costs last week. This was the largest fall since 2012. It happened a week after reaching 2-1/2-year highs.

This was attributed to a cautious ECB reaction against rate-hike wagers. Although markets have been calmed, policymakers still have positions to move in 2022.

BofA analysts point out that if the ECB raises rates next year it will be against its guidelines or signal that inflation is above all predictions.

The recent swings are partly due to a positioning shakeout. This was triggered when Australia failed to protect a crucial target for bond yields, and instead permitted them to soar.

The steady increase in bond volatility this year to highs of 20 months contrasts well with calm on forex and equity markets.

(GRAPHIC: Volatility-https://fingfx.thomsonreuters.com/gfx/mkt/myvmnkagzpr/Pasted%20image%201636540097193.png)

Salman Ahmed is Fidelity International’s global head for macro. He believes the Fed deliberately left out the FAIT parameters to allow it the possibility of acting if inflation remains high.

“This causes a growth/inflation tango which the bond markets are switching back-and-forth from,” he said.

What trajectory inflation follows will determine the outlook.

Surveys by Purchasing Managers indicate that vaccines and easing travel restrictions are already increasing demand for services, over consumer goods. That should ultimately ease supply chain tensions.

Paul O’Connor from Janus Henderson, head of multiasset, says that a services boom will be more likely to create wage pressures, which policymakers may find difficult to ignore. Central bank loans will support equity investors’ gains. Equity investors are the ones to watch.

He said that there may be more volatility in fixed-income markets, as people struggle to determine what policy reaction to inflation to labour market growth might be.