Inflation Volatility In A New Regime: Consequences for Central Banks and Markets

Following the COVID pandemic, Russia’s invasion of Ukraine, and the latest crisis in the Middle East, it seems that bigger and more frequent supply shocks are the likely new regime. If these supply shocks skew negative — as indeed they have been — then that translates into higher and more volatile inflation (Exhibit 1). This is a radically different environment to the period before the pandemic, when inflation was low and stable. There are several implications for central bank policy and, ultimately, markets. Central banks will likely be more reactive to inflation shocks, and in doing so, they will help dampen long-end inflation expectations. Combined with appealing all-in yields, this creates a supportive backdrop for investing in a range of fixed income assets.

The first policy implication is that, in an environment of curveball shocks, central banks will prefer to exercise optionality. They will likely be more hesitant to commit to a given rate path based on what is known today and be more willing to change course as the facts change. (Read our blog post, Dot Dismissal: Scenario Analysis in a Regime-Changing World.) With much higher and more volatile inflation post-COVID, it will be more difficult for central banks to commit to a policy path.

Exhibit 1

Central Bank Rates and Inflation, Pre- and Post-Pandemic

A second implication is that, in an environment of high and volatile inflation, and with policy rates closer to neutral, interest rates are less likely to be at the effective lower bound. As a consequence, central banks will shy away from forward guidance as a commitment device for holding rates low indefinitely, as was the case in the pre-COVID decade.

Finally, with inflation likely to be further away from target and for longer periods than had been the case previously, central banks will need to be more active in order to demonstrate their commitment to the inflation target. Looking through supply shocks doesn’t mean do nothing when it comes to adjusting policy rates.

Inflation Volatility and the Frequency of Policy Moves 

This environment of prolonged above-target inflation and the consequent increase in inflation attentiveness may lead to an asymmetric de-anchoring of inflation expectations to the upside in which expectations respond more quickly or even disproportionately to upward price shocks. Central banks may respond to deviations in shorter-term expectations in a more timely fashion to prevent the entrenchment of above-target expectations and inflation, necessitating a more forceful and lengthy monetary policy adjustment. Successful anchoring of expectations in this way could, in turn, result in shorter rate cycles.

The bottom line is that the new regime is likely to translate into more central bank policy changes and, hence, a more volatile short end of the yield curve. Moreover, increased volatility at the short end ripples through to long-end rates, making them more sensitive to changes in policy rates as well, other things being equal. However, other drivers of the long end, the so-called term premium, could offset the effect of increased short-end volatility at the long end. 

Implications Across the Curve 

In particular, we showed in a previous blog post that inflation uncertainty is an important part of the term premium. Credible central banks that are seen to fight inflation can additionally influence the long end by compressing inflation expectations. This therefore leads to two market implications. First, that volatility will likely be higher in the absence of forward guidance, and second, that front-end volatility will likely be higher than long-end volatility, as was the case in the mid-1990s (Exhibit 2).

Exhibit 2

Short- vs. Long-End Volatility

The post-pandemic period offers a natural experiment for how policy can affect long-end rates as guidance is abandoned in the face of inflation shocks. Exhibit 3 shows that breakeven inflation fell rapidly as the Fed hiked rates aggressively in 2022. And there are echoes of this dynamic following the latest oil shock and the hawkish shift by the market as well as with a Kevin Warsh-led Fed.

Exhibit 3

Relationship Between Policy Rates and Breakeven Inflation

Another component of the term premium — supply/demand imbalances in bond markets — is also linked to central bank policy. With policy rates no longer at their effective lower bound, central bank balance sheets are now contracting. We don’t yet know what central bank balance sheets will look like in the new regime, but the experience so far suggests the following.

First, the theory that balance sheet contraction should be largely neutral has indeed been borne out in practise. That would suggest that balance sheets can be smaller than perhaps anticipated at the start of quantitative tightening.

Second, new liquidity tools designed to act as an escape valve are showing some early signs of working. (Take the Bank of England’s relatively new Short Term Repo facility as a recent example.) That should give central banks confidence that, so long as the additional escape valves are seen as usable by markets, they can indeed continue to shrink balance sheets lower.

Third, the principle of price discovery in a well-functioning democratic capitalist system has not gone away. Indeed, central banks are saying this when they emphasise that it is important for the footprint of the central bank to be efficient, meaning to be as small as possible whilst acting as lender of last resort. The appointment of Mervyn King, Jeremy Stein, and Raghuram Rajan to lead on Warsh’s recently announced task forces is a reflection that these views are in the ascendant.   

A Supportive Backdrop for Fixed Income 

Alongside committed central banks, debt management offices have remained focused on efficiency when raising debt, reducing issuing debt at the very long end and skewing towards shorter-dated maturities. This helps reduce supply and keep yields at the long end contained. The adjustment in supply against a backdrop of resilient demand creates strong market technicals that should help cap volatility at the long end. (This is the supply/demand imbalance driver of rates, especially at the long end.)

Ultimately, the commitment of independent central banks to price stability, efficient debt management, and strong market technicals is expected to override the impact of smaller central bank balance sheets on the volatility of long-term rates. Putting that together implies a new regime of increased volatility at short-end rates and higher but ultimately range-bound, long-end yields — in other words, a compelling environment for fixed income when considering that yield is destiny.