Central bankers face economic downturn and limited ability to tighten financing conditions at Sintra conference

Rates Spark: The battle to keep policy tight

At Sintra, hawkish central bankers meet a deteriorating economic outlook, and face their diminished ability to tighten financing conditions. Inverted curves and lower real rates may be the counterproductive product of their single-minded focus.

 

Hawkish messaging is only credible if the economy holds up

As the European Central Bank’s (ECB) Sintra conference get underway, central bankers will have their eyes firmly on two important checks on their recent hawkish charge. Firstly, a deterioration in economic outlooks, illustrated by the plunge in Germany’s Ifo index published yesterday, limits the credibility of any aggressive hawkish tone with markets fearing a recession. Secondly, it is not altogether certain that, in isolation, a more hawkish central bank results in materially tighter financial conditions.

 

The first concern can in theory be addressed by a single-minded focus on backward-looking inflation. This is the strategy adopted by most central banks, also justified by their poor track record in forecasting inflation. By and large, this strategy has been successful in delaying rate cut expectations, but the central banks’ sphere of influence typically doesn’t reach very far up the curve, so the economic outlook still matters. Dhingra and Tenreyro have an easier job communicating the Bank of England’s stance when they speak today, given the UK’s entrenched inflation problem. Things are more challenging for Lagarde given the deterioration of European economic data.

 

Long-end EUR real rates have declined since May, hardly a tightening of financial conditions

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