The great central banking bluff

Six major central banks delivered decisions in the last eight days and five of them had the same thing in common — a dovish surprise.

Why did they all tilt unexpectedly? Is there something else going on?

The easy answer is that they shifted because the facts shifted. The growing consensus of a looming global recession will restrain demand and prices. Maybe. But I’m starting to think the largely-simultaneous shift isn’t a coincidence.

Hear me out.

Monetary policy is a famously blunt instrument. When you hike rates you hurt both the most-wealthy and the least-fortunate. What if there was a way to tilt the scales in a way that saved the least-vulnerable from some harm?

If that were my goal, here is how I would go about it: By bluffing.

Fed hikes impact markets in two ways

  1. Directly
  2. Via expectations

The direct effect of rate hikes is felt most-acutely by consumers when actual hikes register. The expectations channel hits harder via financial markets. Think about how stock markets recoil to rate hikes. Yesterday’s hawkish press conference from Fed chair Jerome Powell cost equity markets $1 trillion — None of that was taken from the pockets of the least-wealthy in society, at least not directly.

So if you wanted to tilt the scales, you would stoke high-rate expectations for as long as possible before hiking actual rates less than expected. Think of it like a race car driver who stays on the throttle for as long as possible before braking right before the turn.

At the wall of champions F1 drivers brake as late as viable

I think the Bank of Canada’s move last week was the best example of this. A 75 basis point hike was 80% priced in ahead of the decision but Governor Tiff Macklem surprised with a 50 basis point hike.

Just three weeks before the announcement he spoke and delivered a hawkish message, saying that more information was needed before shifting to a meeting-by-meeting approach. Then, just a eight days later the September CPI report was higher than expected but he still delivered a dovish surprise.

The problem is that the Canadian housing market is crumbling and by setting actual rates lower, you help keep people in their homes. That’s especially true with some many variable-rate mortgages in Canada.

For Macklem, bluffing on hikes until the last possible minute was the optimal policy.

The thing is, the only way it works is if you have credibility and if markets don’t figure it out so central bankers can’t talk about.

So if I were the Fed, I’d keep on bluffing right through year end as corporations set their budgets for 2023 and stock market investors are hit with a wave of tax-loss selling.

“Tax loss selling is the biggest risk to the market going into year end. I believe this is the biggest tax loss selling opportunity in two generations,” Jeff Gundlach said yesterday.

Now the Fed doesn’t have a crystal ball; rate hikes above 5% may ultimately be needed. But by bluffing now you can keep a lid on equity markets and restrain financial market excesses. All else equal, that will mean that fewer actual hikes will be needed.

Powell offered the slightest hint at this strategy yesterday but diving into different time lags:

“The way I would think about that is, you know, it’s a commonly, for a
long time, thought that monetary policy works with long and variable
lags, and that it works first on financial conditions and then on
economic activity and then perhaps later on that even on inflation. So
that’s been the thinking for a long time. There was an old literature
that made those lags out to be fairly long. There’s newer literature
that says that they’re shorter. And, you know, the truth is we don’t
have a lot of data of inflation of this high in what is now the modern

One big difference now is that it used to be that you would
raise the federal-funds rate, financial conditions would react, and then
that would affect economic activity and inflation. Now financial
conditions react well before an expectation of monetary policy. That’s
the—that’s the way it has moved for a quarter of a century, is in the
direction of financial conditions, then monetary policy. Because the
markets are thinking, you know, what is the central bank going to do?”

So what’s the trade?

I wouldn’t expect the Federal Reserve to offer a dovish signal before it’s delivered in an FOMC statement. The ongoing message will be tilted towards higher rates and staying vigilate on inflation. However at some point — likely in one of the next four meetings — the Fed will surprise markets with a less hawkish decision or message. That will come either by hiking less like the BOC or by signaling a pause.

In terms of trading, that argues for staying cautious up until Fed day itself.


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