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When politics and inflation collide

18 November 2016
Richard Kemmish

After an unexpected popular vote, the stock market rallied, bond markets didn’t, and break evens in the inflation bond market leapt. The popular vote was heavily criticised by foreigners and it was alleged that globalisation and free trade had passed their zenith. The central bank governor was criticised by politicians to the extent that the independence of monetary policy was bought into question.
Which is as far as the Brexit/Trump election comparison can take us. What happens next is oddly divergent: the Bank of England decided to cut policy rates after a long period of shocking stability, the probability of the long awaited Fed rate hike has, at the time of writing, gone to 92% at their next meeting.

In monetary policy as in politics, the Trump/Brexit comparisons are hopelessly facile.

Arguably the rational for the Bank of England’s rate cut and that for the Federal Reserve’s expected rate hike are the same: both are trying to neutralise the effect of an external shock to their economy in order to better target that which they are supposed to target without political consideration, 2% inflation. 

In the British case the shock was initially expected to be deflationary via the mechanism of lower business and consumer confidence (lets overlook that this either didn’t happen or was hopelessly overshadowed by the impact of the exchange rate move). In the American case when the vitriol had died down a little, the realisation was that the macro-economic shock would be reflationary – via tax cuts and increased government spending.

But the big difference is that the deflationary shock – whether it happens or not and whether it is correctly read by the Bank of England or not – was a bug, not a feature of the political decision. Therefore the Bank of England’s actions did not contradict government policy.

I would argue that an inflationary shock (stimulus, call it what you will) is the policy of the president-elect (who would have thought that Donald Trump would be a follower of Keynes – a man he would have disliked on every conceivable level). So the Fed’s politically impartial objective – 2% inflation – somewhat bizarrely guarantees that it must attempt to neutralise government policy. America will press on the fiscal accelerator and the monetary brake at the same time. I know that is a bad idea in a car (ever tried left foot braking?) but I have very little idea what its implications are for inflation linked bonds, or for Mrs Yellen’s chance of reappointment.
The other parallel between Brexit and the presidential election is that both will have profound implications on the US TIPS market. At the last Euromoney US Real Return conference in September I realised the extent of concern in the UST market about the destabilising effect of Brexit, via the mechanism of European holdings of US government bonds. I can’t wait for next September’s conference to better understand the implications of the new government’s policies on both the supply of TIPS and inflationary prospects.

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