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The credibility gap is widening, with financial markets looking for one thing and central banks delivering another.
In essence, financial markets are worried about inflation and want higher interest rates. But both the Bank of England and the U.S. Federal Reserve are more worried about growth. The result at the moment is stalemate, with both the pound and the dollar likely to pay the price if investors reckon the central banks are getting it wrong.
Financial markets had been celebrating earlier this week, pushing the pound higher on the assumption that the Bank of England was caving into pressure and was about to signal a rate rise.
But they had read the bank wrong.
BOE governor Mervyn King made it clear that as far as he is concerned inflation pressures are set to subside. In fact, if U.K. growth doesn’t accelerate from current levels, the risks of second-round inflation effects will diminish even more, making rate increases even less likely.
The Fed, meanwhile, sent a similar dovish signal to the markets with the publication of its FOMC minutes, also on Wednesday. As anticipated, given the recent strength of U.S. economic data, the Fed was far more optimistic, suggesting 3.9% growth this year.
But, with the housing market still struggling to recover, and the labor market remaining soft, the U.S. central bank made it clear that its quantitative easing program is here to stay. The trouble is, inflation data are also pointing to bubbling producer price pressures in the U.S., casting serious doubts over whether the Fed is being hawkish enough.
And, as with the Bank of England, many in the financial markets think the Fed is wrong.
Commerzbank sums it up.
“All the Fed could do to revive the labor market has already been done: fuel growth. The rest has to be achieved through labor-market policy, tax policy and structural policy. Excessive monetary-policy stimulation is dangerous as it risks creating new asset bubbles, inflation and in the end a weaker dollar.”
The level of concern about global inflation pressures, fed largely by the rally in food and other commodity prices, can already be seen in the recent wholesale reversal of many funds switching out of emerging markets on fears that growing price pressures will erode the returns from these once profitable markets.
The problem for central banks such as the Bank of England and the Fed is that if investors now start pulling out of the pound and the dollar, both of these currencies will fall, making the U.K. and the U.S. even more vulnerable to imported inflation pressures.
As hawkish BOE monetary policy committee member Andrew Sentance warned on Thursday:
“We need to ensure that a weak or declining currency is not aggravating imported price pressures and destabilizing the path of inflation over the medium term.”
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The Source is WSJ.com Europe’s home for rapid-fire analysis of the day’s big business and finance stories. It is edited by Lauren Mills, based in London.
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