A major driver for fixed income markets is central bank policy. A high level of transparency and clear reaction function of central banks are therefore important for predicting bond yields. It is probably in this area that the greatest uncertainty lies at the moment for fixed income markets. In Euroland it is pretty clear that growth is slowing and inflation is coming off its peak. Using history as a guide, the reaction from ECB (or Bundesbank before that) would be rate cuts - as would be implied by the so-called Taylor rule. However, the reaction function is less clear as there seems to be two schools developing within the central bank community.
The traditional school reacts broadly in line with the Taylor rule and is fairly activistic. Lower growth is expected to lower inflation in the medium term due to more slack in the economy. This in turn implies lower central bank rates. It is pretty much how policy has been governed over the last 10 years and explains why ECB cut rates in 2001 when inflation at 3% was clearly above their target. Another school is gaining ground, though, which could be called the non-activist school. They broadly see the current problems as an effect of overly loose monetary policy in the past. Policy makers have been too activistic and put too much weight on short term factors rather than structural factors that impact inflation in the long run. This school is not convinced that lower growth will lead to lower inflation. They put weight on money growth and structural drivers such as globalisation. They are also more worried about a de-anchoring of inflation expectations.
The rate hike from ECB in July likely represents the growing influence from what we have labelled the non-activist school. But the two schools are present in all central banks, which can be seen in the great division of views within FOMC (where Fisher still votes for a hike), and Bank of England (where Besley votes for a hike while Blanchflower votes for a cut).
The traditional school reacts broadly in line with the Taylor rule and is fairly activistic. Lower growth is expected to lower inflation in the medium term due to more slack in the economy. This in turn implies lower central bank rates. It is pretty much how policy has been governed over the last 10 years and explains why ECB cut rates in 2001 when inflation at 3% was clearly above their target. Another school is gaining ground, though, which could be called the non-activist school. They broadly see the current problems as an effect of overly loose monetary policy in the past. Policy makers have been too activistic and put too much weight on short term factors rather than structural factors that impact inflation in the long run. This school is not convinced that lower growth will lead to lower inflation. They put weight on money growth and structural drivers such as globalisation. They are also more worried about a de-anchoring of inflation expectations.
The rate hike from ECB in July likely represents the growing influence from what we have labelled the non-activist school. But the two schools are present in all central banks, which can be seen in the great division of views within FOMC (where Fisher still votes for a hike), and Bank of England (where Besley votes for a hike while Blanchflower votes for a cut).
