A recent spike in inflation expectations has left many investors guessing how central banks would respond. Judging from the spike in yields of the widely watched US 10-year treasuries and selloff of long duration equites, it seems most investors expect the Fed and other central banks to tighten the monetary policy sooner than planned. We think the Fed will be more concerned about the stability of the financial system and sustaining the ongoing economic recovery more than inflation risk. Therefore, instead of tightening the monetary policy as expected, the Fed may go the opposite direction.
With fiscal deficits and corporate borrowing at record highs, low and stable interest rates are a necessity for the stability of the financial system. If nominal interest rates rise, defaults will escalate which will not only stall economic recovery but destabilise the financial system.
Our view is not farfetched. The European Central Bank has already fired the first salvo in this direction after announcing that it will speed up money-printing to keep a lid on borrowing costs, using its €1.85tn Pandemic Emergency Purchase Program (PEPP) more generously over the coming months to stop any unwarranted rise in debt financing costs. The only challenge with easing the monetary policy at this point is that it could fuel inflation fears. Targeting certain sections of the yield curve may be an easier option for the Fed.
Source: Federal Reserve Bank of St. Louis