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Central banking is a funny old game. Mervyn King knew this in 2005 when, as governor of the Bank of England, he articulated the ‘Maradona interest theory’. Lord King talked about the ability of central bankers to move the markets with words, changing the restrictiveness of policy and giving central bankers the opportunity to do nothing.
It was, he said, a bit like the Argentine striker running in a straight line to score against England in the 1986 World Cup quarter-final while England defenders danced around him, always expecting a move to one side or the other.
Since Governor King made his analogy, forward guidance and financial conditions have become an important part of central bankers’ toolbox. And this was on display at policy committee meetings around the world in March.
The Bank of England, the European Central Bank and the Federal Reserve all delivered messages of varying aggressive intensity, from most aggressive to least aggressive respectively. Market expectations regarding interest rates have since been sharply revised, with particularly large interest rate revisions in the interest rate-sensitive short-term government bond markets.
For example, two-year government bond yields have risen by 0.38 percentage points in the US, 0.59 percentage points in Germany and 0.85 percentage points in Britain since the beginning of March.
The interest rate futures markets have undergone a similar revaluation and are now pricing in a strong likelihood that the BoE and ECB will raise rates at their meetings in April and again in the summer. US futures markets indicate that the Fed will keep interest rates unchanged throughout the year. These changes represent a sharp reversal from market expectations before the start of the war.
In many ways this is the Maradona effect at work. Market prices have changed and financial conditions have tightened, allowing central banks to ensure that a rise in inflation due to higher energy prices does not become permanent. In Britain, BoE Governor Andrew Bailey has even suggested that the tightening of financial conditions has gone too far.
The effects are already having an impact on the real economy, especially on the housing market. UK fixed mortgage rates for two- and five-year deals are now back to the level of almost 6 percent that prevailed when the BoE’s policy rate was 5 percent. US mortgage applications fell by 10 percent in the last week of March. Together with higher oil prices, which in themselves represent a tightening, these market movements will impact demand and help prevent persistent inflation.
Such has been the rapid financial tightening since the March central bank meeting that there is some concern that the ‘stag’ part of the incoming stagflationary shock may warrant more concern than the ‘flation’ part.
With looser labor markets, economic conditions in the US and Britain appear less sensitive to the second round of inflationary effects than after the 2022 energy price shock.
“Financial conditions have deteriorated significantly since the Bank of England meeting in March. In addition to low growth and increasing labor market slack, the risks of second-round inflation effects are lower today than in 2022 and the risks of a non-linear adjustment in activity are higher,” said Sanjay Raja of Deutsche Bank.
If tighter financial conditions hit hard, we can first expect a slowdown in housing market transactions, in addition to a decline in consumer confidence.
“What worries me most is the one-sided impact on households. Mortgage costs are now rising, but savings rates are not following at the same pace. Mortgage rates are now 75 to 100 basis points higher every month. On a £250,000 repayment mortgage that equates to around £1,200 to £1,800 extra per year, but with little offsetting benefit for savers. That’s a real pressure on people,” says Alex Beavis of British lender LHV Bank.
If stock prices also fall, the risk to the U.S. economy could be greater. “We are already seeing the impact on the housing market of tighter financial conditions, but a bigger concern for me is the impact on consumption that could come via the wealth effect if share prices continue to fall,” said Jonathan Pingle of UBS. With the US savings rate already low, households do not have such a large buffer if their wealth were to decline significantly.
Bailey and other central bankers have successfully pulled off the first part of a Maradona-like move. It is already limiting the demand side of the economy.
This has bought officials time while they wait for more clarity on the intensity and duration of the energy shock and how it will spread through the economy.
That’s useful for now and may allow them to keep interest rates unchanged, but ultimately it won’t work forever. Tighter financial conditions, based on higher interest rate expectations, will only persist if central bankers ultimately back up the rhetoric with action.
