Never Underestimate Central-Bank Groupthink
Markets increasingly believe monetary policy will chart different paths across Western countries, but divergence could be short lived
By Jon Sindreu
Traders see the Federal Reserve being less hawkish from now than the European Central Bank, and the Bank of England racing ahead of both. PHOTO: BRENDAN MCDERMID/REUTERSSeeing how Western economies are all in different places, maybe central banks will also try to go in different directions.
Then again, maybe not.
After a year and a half of interest rates going up almost everywhere—China and Japan being the exceptions—signs have piled up this month that monetary policies could finally start to diverge.
On one side are countries where inflation has declined and officials could soon stop tightening.
Investors believe the Federal Reserve will only raise rates once more this year, even after Chairman Jerome Powell suggested Thursday that he aims to do it twice.
After tightening policy last week, the Swiss National Bank is signaling a softer approach.
A second group comprises central banks that have become more hawkish despite moderating inflation, like the Bank of Canada and the European Central Bank, which seems unfazed by data showing a recession in the eurozone.
Finally, there are those becoming more aggressive as a result of inflation not budging, such as the Reserve Bank of Australia, Sweden’s Riksbank and Norway’s Norges Bank.
Above all, there is the Bank of England, which raised borrowing costs last week and appeared to affirm market expectations that they will go as high as 6%, imperiling Britain’s property-dependent economy.
Such a range of situations would seem to require a range of solutions, and so investors are starting to bet on central-bank decoupling.
Over the past three months, yields on two-year government debt have risen far less in the U.S. than in other Western countries, with the U.K. leading the pack.
At the center of market ructions sits the U.S. dollar, which stands to lose some of the outsize strength it accumulated during the pandemic.
The WSJ Dollar Index is down 1.4% this past month, which makes the overseas earnings of American firms appear greater, boosting the S&P 500 at the expense of foreign stocks.
It also makes U.S. exports more competitive versus other countries’.
But will central-bank divergence last? There are reasons to doubt it.
For one, it bucks the longer-term trend.
In the 1990s, less than 60% of developed-nation central banks went along with the majority policy setting.
Over the past decade, it has averaged 80%.
Although officials have more leeway to set domestic policy now than in the Bretton Woods era of fixed-exchange rates, the influence of the dollar often encourages other nations not to deviate too much.
A key factor is that economic growth and inflation have become increasingly globalized, some research finds.
While tensions with China could loosen some links, Western economies remain joined at the hip.
Right now, differences between the U.S. and Europe might seem larger than they are because of the postpandemic rebalancing of spending from goods to services and the greater weight of manufacturing in the eurozone.
Likewise, Britain’s anomalously high consumer-price inflation seems likely to converge with its producer-price inflation, which dropped to 0.5% in May, from 23% a year earlier.
Crucially, unemployment rates have remained low across rich nations.
To be sure, economic gaps may widen regardless.
Surveys of purchasing managers suggested Friday that services industries are weakening significantly in the eurozone, Britain, Japan and Australia, yet much less in the U.S.
Even so, central banks have another reason to cluster: groupthink.
In 2021, Western central bankers all but unanimously called inflation a “transitory” phenomenon driven by bottlenecks.
Then, in 2022, they suddenly became extremely hawkish and embraced demand-led explanations, despite the war in Ukraine.
An identical response across geographies is odd, not the least because fiscal generosity during the pandemic varied greatly country by country.
Conformity may reflect Western officials’ similar cultural and academic backgrounds. Tellingly, the Bank of Japan has gone against market expectations and kept stimulus measures in place, at least so far.
Roger Hallam, Vanguard’s global head of rates, also points out that central bankers’ confidence was damaged when they got their forecasts wrong: “They are uneasy with the idea that they have a strong grasp on what is causing inflation.”
Uncertainty makes it more attractive to follow the herd, because getting it wrong is less costly if others are also wrong.
Rate-setters, particularly at the ECB and the BOE, have struggled to offer theoretical justifications for their actions lately, often warning about wage-price spirals without their own research bearing it out.
They are in a tough spot: Their reputations depend on hitting an arbitrary 2% inflation target when factors out of their control often dominate.
Post-2008 monetary experimentation was the same in reverse.
Central banks collectively undershot inflation and aped each other with massive “quantitative easing” programs without a consistent view of how they worked.
What was touted as a silver bullet has now quietly been reclassified as mostly ineffective.
An April speech by the BOE’s Silvana Tenreyro is a recent example.
Monetary divergence is still likely in countries where inflation returns to 2%, as could happen soon in Switzerland.
In most places, however, investors may find that the “higher for longer” mantra works regardless of domestic economic conditions.
At least, that is, until central banks collectively change their minds.
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