The shifting tide of monetary policy
Over the course of 2021, the monetary policy tide has clearly shifted. Whereas 2020 was the year when ample liquidity was pumped into the financial system, 2021 was the year when central banks began withdrawing some of that liquidity as inflationary pressures mounted.
As illustrated in the table below, emerging markets took the lead, with central banks in Brazil, Russia and Central and Eastern Europe initiating sharp tightening cycles. The Central Bank of Brazil (BCB) has been particularly aggressive, hiking its policy rate by 725 basis points already in 2021, and with additional rate hikes foreseen for the first quarter of 2022.
The table below also makes clear that the main driving force behind the policy shift has been persistently rising inflation pressures that have moved above central bank target rates in a number of countries. While base effects and an easing of supply-side bottlenecks should lead to a moderation in inflationary pressures over the course of 2022, the upside risks to inflation and inflation expectations have kicked central banks into action and set the stage for further tightening this year.
A quick look at the below chart provides some important takeaways for understanding the current policy landscape. First, emerging markets may have led the way, but advanced economy central banks have started hiking as well, most recently with the Bank of England raising its policy rate from zero to 0.25% in December.
Second, aside from the outlier case of Turkey, the US stands out on this chart for having the highest current inflation rate relative to target among major economies that have yet to hike. In line with this, (and given the strong recovery in growth and the labour market since the onset of the pandemic) the Fed has recently changed its tune on the timing of policy tightening. Following the release of the minutes for the December FOMC meeting, the Fed is now expected to implement a first 25-basis point rate hike in March 2022, coinciding with the conclusion of its accelerated tapering of asset purchases, followed by three more 25-basis point rate hikes in 2022.
Third, while inflation is above target in the euro area as well, the difference is less pronounced compared to the US or the UK. This, together with ECB staff projections that show inflation returning below target in 2023, gives the ECB room to hold off on liftoff for longer (likely only in 2023).
However, with the tides of monetary policy developments quickly shifting, market participants may pick over the ECB minutes released tomorrow to gain any additional insights into the ECB’s timeline. Likewise, the Fed meeting next week and the ECB meeting the week after will be carefully watched for any signs that policy tightening from either central bank could be more substantial, or come earlier, than what is currently priced into markets.
