Central bankers and markets have shifted their focus squarely on inflation risks. The ECB is about to turn words into actions; Fed officials came out in force to stress their determination to keep inflation expectations in check; the Bank of England has adopted a more hawkish stance and the Bank of Canada yesterday declined to validate market expectations of a rate cut. Financial markets are now pricing in a rather aggressive tightening in the Eurozone, US and UK. Are central banks' concerns justified? And will they act as aggressively as the market seems to expect?
I believe actual monetary tightening at this juncture would be premature and risky, and that central banks are further away from tightening cycles than markets are pricing, so that expectations of rate hikes are overdone. I also maintain that the ECB's communication strategy has proved disappointing at a very delicate and important juncture. I do however have sympathy with the central banks' underlying concerns. Should commodity prices continue to rise, inflation expectations might eventually become unmoored-but this would be only one of several very serious problems: a global recession would likely follow. This would be a very ugly scenario with no winners-it is hard to see how even commodity exporters could escape unscathed-and virtually all asset classes would suffer I do not think this will come to pass, and central banks are right in talking tough and striving to keep expectations anchored while we wait for commodity prices to at least decelerate. The real danger however is that should the commodity bull run continue unfettered, the matter may well be out of their hands.
