Financial market stress is not abating. On the contrary, central banks openly admit that their inflation forecasting capability has been short of the mark. Even if this is the case and no dynamic stochastic general equilibrium (DSGE) model has been of any help, central banks should improve and work on their guidance with respect to terminal policy rates. The DSGE models essentially are built on the interaction between demand, supply functions with the monetary policy reaction function. These DSGE models have driven policy making over the past decades. They rely on a set of assumptions related to perfect competition, instant and comprehensive price adjustments, rational expectations, lack of information asymmetry and uniform behaviour of firms and households. It becomes obvious that the pandemic and geopolitical stress present today do not make for a good fit with such models. So, central banks have decided to stick to a ‘simple’ response: “We only focus on fighting inflation and anchoring inflation expectations. Increasing policy rates will be the blunt instrument of choice.”
Unfortunately, such communication strategies increase uncertainty. It is supporting the ‘moving goalposts’ narrative I commented on some weeks ago. As inflation prints in the EU and the US held above the 8%+ digit central banks might have to go beyond the central tendency of the highs in policy rates as priced by markets. That would see US FED fund rates touch 4% (or higher) or ECB policy rates reach 2.5% (or higher). Demand across goods and services would be curtailed aggressively. That would break the back of inflation.