Focusing on current dynamics, with forward guidance 2.0 on its way, we think that the current weakness in US data (if sustained beyond March) is likely to have a magnified positive impact on core fixed income asset prices.
Unemployment focus
Medium term, the efficacy of both the Fed`s and Bank of England`s current monetary policy set-up will be decided by the trajectory of inflation.
So why are central banks scrambling to change their guidance now?
The answer lies in the drivers of the forward guidance framework. Both the Fed and BoE connected their forward guidance to the jobless rate. While the unemployment rate fell sharply in both countries, the source of the fall has become a contentious policy issue (especially in the US) given the role played by the decline in labour force participation.
For instance, in the US the labour force participation rate has fallen (because of demographic changes and cyclical factors) by 3.1% since mid-2008 and explains a significant chunk of the decline in the jobless rate. The precise contribution of cyclical versus structural factors is debated. Ben Bernanke and more recently Janet Yellen have characterised the jobless rate as an imperfect measure of the state of the labour market and have in turn expressed preference for cyclical explanations behind the labor force decline.
Where does inflation fit into this?
BoE had an inflation condition in its original forward guidance framework, given the central bank is an inflation targetter, while the Fed has in recent months also increased its emphasis on inflation, as the jobless rate has fallen towards the threshold. The focus on inflation is also convenient in the sense that it has been falling in the UK, and has remained subdued in the US in recent months.
Indeed, persistently low or falling inflation is also used as supporting the cyclical drivers-explanation behind the decline in the labour force participation rate and has been used by the doves to argue that monetary policy still has a role to play in supporting economic growth.
However, various academic studies show that the relationship between inflation and unemployment tends to be non-linear, especially when jobless rate is too high. This implies inflation will ultimately decide the efficacy of the current monetary policy set-up adopted by the BoE and the Fed.
Missed hysteria
The non-linear dovish power of forward guidance will come into play again (even if temporarily), when key economic variables start to surprise to the downside again. Focusing on current dynamics, markets have continued to ignore the persistent series of weaker-than-expected US economic data, which is partly explained by weather-driven distortions. However, if this trend of weakness continues, then any ensuing rally in fixed income is likely to be magnified in this forward guidance 2.0 world.
Forward guidance was never a promise, so some of the hysterical criticism of the Fed is unfair. It was an expectations management tool to ease financial conditions. With the rise in yields witnessed over the past year, the balancing act is back in play against a backdrop of low inflation. If markets price in hikes and key central bankers agree with that assessment, then one can argue that the optionality created by the forward guidance has expired.
Inflation focus
However, given the shift towards inflation in this second iteration of forward guidance, it appears that the Fed/BoE still wants to retain this non-linearity in the market expectations spectrum, in case the ongoing recovery stalls again like in 2010/11.
That said, from a more medium-term view, from both a market and central bank perspective, the relationship between inflation and the unemployment rate will be key. If inflation were to start rising again, then credibility of both Fed and the BoE can potentially be questioned, given the current easing biased monetary policy framework of both central banks.
