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Central banking is a funny old game. Mervyn King knew this in 2005 when he expressed the “Maradona theory of interest rates” as governor of the Bank of England. Lord King was talking about central bankers’ ability to move markets with words, changing the restrictiveness of policy while allowing central bankers to glide along doing nothing.
It was, he said, rather like the Argentine striker running in a straight line to score against England in the 1986 World Cup quarter-final, while English 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 a key part of central bankers’ tool kits. And this was on display in the March meetings of policy committees around the world.
The Bank of England, the European Central Bank and the Federal Reserve all served up messages of varying hawkish intensity, the most aggressive to the least, respectively. Market expectations of interest rates have repriced sharply since, with especially large repricing in the interest rate-sensitive short-maturity government bond markets.
Two-year government bond yields, for example, have risen 0.38 percentage points in the US, 0.59 points in Germany and 0.85 points in the UK since the start of March.
Interest rate futures markets have repriced similarly and now price in a strong chance that the BoE and ECB will raise rates at their April meetings and again in the summer. US futures markets point to the Fed keeping rates on hold all year. These changes represent a sharp reversal from markets’ expectations before the war started.
In many ways, this is the Maradona effect at work. Market prices have changed and financial conditions have tightened, helping central banks ensure that any rise in inflation from higher energy prices does not become persistent. In the UK, BoE governor Andrew Bailey has even suggested the tightening of financial conditions has gone too far.
The effects are already feeding through to the real economy, especially in the housing market. Quoted UK fixed mortgage rates for two- and five-year deals are now back to the almost 6 per cent levels that applied when the BoE’s policy rate was at 5 per cent. US mortgage applications were down 10 per cent in the last week of March. Taken alongside higher oil prices, which are a tightening in themselves, these market moves will hit demand helping to prevent persistent inflation.
Such is the rapid financial tightening since central banks met in March that there is some concern that the “stag” part of the incoming stagflationary shock might warrant greater concern than the “flation” part.
With looser labour markets, economic conditions in the US and UK seem less susceptible to the second-round inflationary effects than they were after 2022’s energy price shock.
“Financial conditions have tightened significantly since the Bank of England met in March. Alongside low growth and growing slack in the labour market, 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,” says Sanjay Raja of Deutsche Bank.
If tighter financial conditions hit hard, we can expect first to see a slowdown in housing market transactions alongside a decline in consumer confidence.
“What concerns me most is the one-sided impact on households. Mortgage costs are rising now, but savings rates haven’t followed at the same pace. Mortgage rates are now 75–100 basis points higher month on month. On a £250,000 repayment mortgage, that equates to roughly £1,200–£1,800 extra per year, but with little offsetting benefit for savers yet. That’s a real squeeze on people,” says Alex Beavis of UK lender LHV Bank.
If equity prices also fall, the risk to the US economy might be bigger. “We’re already seeing the impact on the housing market from tighter financial conditions, but a bigger worry for me is the hit to consumption that could arrive via the wealth effect if equity prices keep falling,” says Jonathan Pingle of UBS. With the US savings ratio already low, households do not have as much of a buffer if wealth were to fall significantly.
Bailey and other central bankers have successfully pulled off the first part of a Maradona-style move. It is already constraining the demand side of the economy.
This has bought officials time while they await greater clarity on the intensity and duration of the energy shock and how it will spread through the economy.
That is useful for now and can allow them to keep rates on hold, but it does not ultimately work forever. Tighter financial conditions based on higher rate expectations will only persist if central bankers ultimately underpin rhetoric with action.
