In what may have been a watershed moment in monetary policy – which awkwardly was missed by almost everyone as a result of the concurrent launch of the latest North Korean ballistic missile which immediately drowned out all other newsflow – late on Thursday, the Bank of Canada held a conference on inflation targeting and monetary policy titled “Bank of Canada Workshop “Monetary Policy Framework Issues: Toward the 2021 Inflation-Target Renewal” in which, in a stunning shift of monetary orthodoxy, BoC Senior Deputy Governor Carolyn A. Wilkins said that Canada was open to changes in the BoC mandate.
- WILKINS: OPEN TO LOOKING AT `SENSIBLE’ ALTERNATIVES TO MANDATE
Or in other words, lowering or outright abolishing the central bank’s inflation target, or explicitly targeting financial conditions and asset prices.
While still early in the process, the BOC may be setting a precedent, one which other DM central banks may have no choice but to follow: If the Bank of Canada is going to look at alternatives to their mandate (with an emphasis on inflation), it – as several trading desks have suggested – could become the first central bank to officially change its mandate to reflect financial conditions that are too loose in the context of the current low r-star lowflation environment.
In practical terms, this would mean that instead of seeking chronically easier conditions to hit legacy inflation targets around ~2.0% while inflating ever greater asset bubbles, one or more central banks could simply say that 1.5% (or less) is sufficient for CPI and call it a day, in the process soaking up record easy financial conditions and bursting countless asset bubbles. In the context of a “new supply paradigm” in retail (where even FOMC members now blame Amazon for lack of inflation) and energy (same but with OPEC) which appears to be gaining traction within central banks, as well as frustration with distortion in asset markets, It would make much sense for the Fed to lower the inflation target to 1.5%, declare victory, and normalize policy.
Why? Because as several banks noted after the BoC conference, we know that central banks world-wide are concerned about the size of their balance sheets and associated dysfunctionality in government and other bond markets, and the ever-increasing risks from the ultimate unwind as the QE programs continue to grow in a war against inflation where the victory looks increasingly Pyrrhic. Furthermore, negative rates have caused money markets to become dysfunctional and less efficient, which could be a structural issue “if the temporary was allowed to become permanent.”
What is shocking is that this revolutionary reversal comes just one year after mainstream monetarist dogma was that the solution to stagnant growth was to flood the world with virtually unlimited liquidity, unleashing NIRP across the entire world and even launching helicopter money, in order to protect “lowflation.” One year later, central bankers appear to have made a remarkable, and still largely inexplicable U-turn.
To be sure, it did not start with the Bank of Canada: last week NY Fed president Bill Dudley hinted the Fed could lower the inflation target. As a result, we are now in a situation where many central banks are looking to declare victory and walk off the field, before the unintended consequences of monetary policy kick-in for financial stability. This will lead to greater policy divergence between the likes of the BoC and BoE, Fed, ECB and the BoJ and RBA, but ultimately policies will once again reconverge as more central banks follow in the BOC’s footsteps. .
Then there is the issue of pervasive market froth and countless asset bubbles, which G-6 central banks are well aware of: with a US real 5y rate at 3bps, credit spreads at very tight levels relative to historic cycles, and elevated equity markets, financial conditions are very loose at a time of full employment and cyclical acceleration. Just a few days ago, Fathom Consulting said that there is now a “bubble in everything except housing.”
Following the BOC’s trial balloon, expect similar arguments on revising central bank mandates and changing inflation targets to gather strength in coming months, and be espoused by increasingly more central bankers. It will mean the first fixed income markets will start to re-price accordingly, followed shortly by equities. Ironically, of course, if central banks finally did decide to lower the inflation target at a time of global cyclical acceleration, and the new supply paradigm proved to be an illusion (i.e. a one-off adjustment rather than a permanent factor), the consequences for fixed income would be catastrophic, with the long end being under particular threat, while risk assets would crash.
Indeed, the threat of an equity crash is the only potential hurdle for central banks to go fully public with the new “mandate revision.”
In any case, keep an eye on what central bankers say and do in the coming weeks. As Citi summarizes, “we’ve had a decade of twists and QEs and negative rates and the potential accommodation removal is quicker than asset market prices are currently reflecting. Assets will wait to see the whites of the central bank rates’ eyes now. That’s a real twist!”