Market "Substitutes for Central Bank Rate Hikes"! Western Central Banks "Welcome the Development"

Major global central banks are handing over part of the job of curbing inflation to the bond market in exchange for more room to wait and see.

Tensions in the Middle East have triggered severe volatility in oil prices. Both the Federal Reserve and the Bank of England have hinted that the recent sharp rise in yields has tightened financial conditions to some extent, enough to substitute for actual rate hike operations, allowing both central banks to remain on hold and wait for the inflation trend to become clear.

Federal Reserve Chair Powell attributed part of the tightening in financial conditions at last week's press conference to the dilution of forward guidance, stating that the market is now "playing the ball rather than watching the referee." Bank of England Governor Andrew Bailey also stated that the tightening of financial conditions and the upward shift in the yield curve triggered by the Middle East conflict are suppressing emerging inflationary pressures.

However, this "hands-off" strategy is not without risk. Several analysts warned that the strength of spontaneous market tightening is limited. Once energy price shocks transmit to broader inflation, if central banks delay action, they may repeat the mistakes of the early part of this decade when the pandemic overlapped with the Russia-Ukraine conflict—forcing them to adopt more aggressive tightening, which would cause greater harm to the economy.

Yields Surge, Market "Substitutes" for Rate Hikes

Rising government bond yields penetrate the real economy by increasing borrowing costs for businesses and residents, an effect similar to direct rate hikes by central banks. It is this transmission mechanism that gives the Federal Reserve and the Bank of England the confidence to pause action.

Following Fed Chair Powell's press conference last week, the US Treasury yield curve experienced its steepest widening in nearly a year, with long-end yields rising significantly more than short-end yields. Although the curve flattened somewhat during Monday's trading, the spread remains significantly higher than pre-Fed meeting levels.

Elisabet Kopelman, US Economist at Skandinaviska Enskilda Banken AB, pointed out that such trends "increase the pressure on the Federal Reserve to ultimately deliver on market expectations." In the UK, the spread between two-year and 30-year UK gilts saw its largest single-day fluctuation since March on Thursday, initially driven by the US market and then further widened by signals from the Bank of England that a rate hike is unlikely in the short term.

However, analysts generally caution that relying on spontaneous market tightening has fundamental limitations. James Smith, Developed Markets Economist at ING, warned:

"The risk for central banks is that they must align their words with actions at some point to keep inflation expectations within controllable ranges."

Some Federal Reserve observers warned that Powell and his colleagues might wait too long again this time, whereby more forceful action would push up borrowing costs and cause deeper damage to economic growth.

Notably, the combination of pandemic lockdowns and soaring energy prices triggered by the Russia-Ukraine conflict, coupled with a sluggish central bank response, ultimately led to runaway inflation, forcing a conclusion with more aggressive tightening.

Central Banks Collectively Wait-and-See, with Different Logical Focuses

Faced with this round of energy shocks, the Federal Reserve, the Bank of England, and the European Central Bank have all chosen to incorporate market forces into their policy considerations, but with different focuses.

Powell attributed the tightening of financial conditions to the Federal Reserve's active reduction of forward guidance, emphasizing that the market has assumed part of the policy function. The Bank of England's Bailey directly pointed to the Middle East conflict and the upward shift in the yield curve as suppressing inflation. Although the European Central Bank has already raised rates and the market expects another move in September, President Lagarde also admitted at the July 23 press conference that "more volatile and risk-averse financial markets may suppress demand, thereby lowering inflation."

Evelyne Gomez-Lietchi, Multi-Asset Strategist at Mizuho International Plc., believes that the cautious attitude of central banks is reasonable. "Central banks cannot 'solve' energy price shocks through rate hikes," she said. "It is reasonable to remain prudent on actual rate hikes."

Recent data provides some support for the central banks' wait-and-see stance. The US Consumer Price Index (CPI) fell month-on-month for the first time in six years in June. However, annual indicators still show inflation at high levels—overall CPI rose 3.5% year-on-year, and core CPI rose 2.6% year-on-year.

Ian Lyngen, Head of US Rates Strategy at BMO Capital Markets, stated,

"Powell is content to keep the policy rate stable because the market is bearing the heavy burden. But the counterargument is that effective market tightening can only last for a period, and policy follow-through will eventually need to be seen."

George Moran, European Macro Strategist at RBC Capital Markets, was more direct:

"The magnitude of market tightening is very limited compared to previous rate hike cycles. If shocks transmit more broadly to inflation, central banks cannot rely solely on this."

Unlike Western central banks looking to the bond market, the Bank of Japan is more focused on exchange rate trends—the weak yen has become an additional driver of inflation in Japan.

The Bank of Japan kept the benchmark interest rate unchanged at 1% last Friday, but Governor Kazuo Ueda released hawkish signals at the post-meeting press conference, stating that it is prepared to take action if price pressures spread, keeping the possibility of a rate hike in September open. Meanwhile, the Japanese Ministry of Finance intervened in the foreign exchange market to provide support for the continuously weakening yen.

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