Financial markets improve

The month of July has been good for risk assets such as equities. The main reason appears to be the notion that inflation could be peaking. Taming inflation is the most important objective for policymakers and markets alike, and there is mounting evidence that inflation may become slightly less intense in the coming months – a matter we discuss in more detail later.

The lingering question is whether risk assets can really manage a sustained rise when the economy continues to weaken, a recession is likely, and earnings expectations have not yet significantly fallen. It seems more likely that lower lows await, despite the tentative good news about inflation.

Meanwhile, bond yields are now materially lower than they were in mid-June. The U.S. 10-year yield has descended from a high of 3.48% to 2.78%. This reflects a combination of markets pricing in lower inflation and eventual rate cuts starting in the second half of 2023. This assessment seems about right.

Pandemic advances

The latest COVID-19 wave continues, driven by the Omicron BA.5 sub-variant. Infections are no longer well tabulated, such that it is hard to compare the magnitude of the latest wave to earlier undulations. The wave probably isn’t quite as large as the prior few waves. However, U.K. statisticians nevertheless estimate that 1 in 17 people in England are currently infected with the virus – a remarkable degree of saturation.

Hospitalizations provide some sense for the magnitude of the virus wave, albeit with a significant lag. Most countries are reporting rising, though not high, COVID-19 hospitalization rates (see next chart).

COVID-19 hospitalizations in developed countries are rising

Based on data available as of 07/12/2022. Source: Our World in Data, Macrobond, RBC GAM

As we have argued in the past, the economic damage from additional COVID-19 waves is set to be fairly limited. Governments are unlikely to lock down again, aside from China. The residual damage is from staff shortages as sick people take time off work and more cautious behaviour when people perceive the level of infection around them to be high.

U.S. President Biden now has COVID-19, but is reportedly improving nicely.

Updated vaccines that target Omicron are expected to be released this fall. However, they are optimized to neutralize the now-defunct original Omicron strain, with somewhat reduced efficacy against BA.4 and BA.5. Still, this next generation represents a step forward relative to existing vaccines.

Given the viral wave unfolding this summer – a time when the virus is thought to spread less readily – one worries about what this coming fall and winter may bring. Already, there are reports of what could become the driver of a future wave of infections: the BA.2.75 sub-variant, which is thought to be even more infectious and better at evading immunity. It can now be found in a rising number of countries.

Ukraine war continues

The story remains a familiar one with regard to the Russia-Ukraine war. Russian troops continue to make incremental advances in eastern Ukraine. It promises to be a lengthy, grinding war. Although there have been some predictions of a cease-fire, betting markets now assign a 92% probability that the war will continue at least into December.

Food availability tug of war

A central humanitarian and inflationary concern has been the inability of Ukraine’s enormous agricultural production to reach global markets, blockaded as they are by Russia. This leaves the world’s poorest people hungry, threatening a humanitarian disaster.

Happily, Ukraine and Russia recently struck a deal to unblock these ports. Unhappily, Russia bombed the Odessa port mere hours later. It is hard to know what to make of this insanity, short of Russia’s desire to sow chaos.

Between Russia’s belligerent action and the fact that the deal requires the creation of a joint coordination centre, needs a system of inspections, may require a few months before any ships can fully take advantage of it, and that the initial deal is only valid for four months, it is far from certain that anything will come of it. Still, wheat prices are much less concerned than they were a few months ago. The price of wheat has fallen from more than US$1200 per bushel in late May to under $800 per bushel today. Food supply concerns are easing slightly. Hopefully the grain actually gets to market.

Natural gas prices spike again

European natural gas prices have spiked again on further concerns of Russian supply vanishing (see next chart).

Germany NCGI Natural Gas Index remains high

As of 07/22/22. Source: Intercontinental Exchange (ICE), RBC GAM, Macrobond

It seems unlikely that natural gas prices will normalize any time soon. Russia is highly incented to limit supply, for three reasons:

• The inelasticity of demand for natural gas is such that Russia can actually earn more in the short run by producing less. The price rises by more in response to a shortage than the supply decreases.
• Russia wants to keep Europe off balance by constantly undermining its expectations so that the continent cannot plan for its energy future.
• Ultimately, Russia wants to ensure that Europe does not have enough natural gas for the winter so that Europe is tempted to seek a ceasefire or ceases to fund Ukraine.

In early July, the flow of natural gas through the Nord Stream 1 pipeline had fallen to just 40% of its capacity. This was purportedly due to problems with a turbine. Then, the annual July 10-day maintenance shutdown occurred, raising questions as to whether Russia would ever turn the tap back on.

Fortunately, it did: gas is again flowing through Nord Stream 1, but again only at 40% of capacity. The damaged turbine has been repaired and should be restored to service shortly. Production should therefore theoretically increase. Whether Russia finds other excuses to limit the supply of gas is uncertain, but seems likely.

The European Union (EU) thus faces the prospect that it won’t have enough natural gas inventories to withstand the winter. The European Commission has asked its member states to reduce their natural gas consumption by 15% starting in August so as to have enough to last the winter. In addition to lower demand induced by high natural gas prices, there are reports of a large residential landlord lowering its minimum heating temperature, the hot water being turned off in schools and gyms, and the closure of public swimming pools.

High gas prices are also creating corporate distress. Germany’s largest natural gas importer requires an emergency government loan to avoid bankruptcy.

Should the natural gas shortfall continue into the fall, businesses will have to start reducing their production. We assume the shortfall will worsen as winter approaches, in part due to rising demand, in part due to ongoing or even increased supply limitations. This constitutes a major reason why the Eurozone economic outlook is particularly challenging for the coming year.

Oil price cap?

Western nations are in intense discussions regarding the possible implementation of an unorthodox price cap on Russian oil. In essence, the rest of the world would form a cartel that refuses to buy Russian oil above a certain price, such as $45 per barrel. This is less than half the market rate, but high enough to still be profitable for Russia. In so doing, the market cost of oil would be effectively reduced, lowering inflation and helping the global economy while punishing Russia.

How to enforce the price cap? Ship insurers would be banned from providing insurance for Russian oil purchases not subject to the cap. Of course, the devil is in the details. Would limiting insurers be enough to halt the flow of Russian oil? Couldn’t non-compliant countries take their chances with uninsured shipments? What would stop third-party countries from reselling the cheap oil at a premium? How would the cheap oil be allocated between countries?

It is fascinating idea, but of unclear practicality. Further, there are potentially frightening implications for the global economy should the idea spread beyond this special scenario. If countries decide that food prices are too high, would they also coordinate their purchases to set a lower price for that, too? What about for other products? The risk is that free markets are undermined, resulting in the misallocation of capital, the misallocation of resources, and severe shortages later.

Big currency moves persist

The U.S. dollar has been extremely strong in 2022. Conversely, the likes of the euro and the yen have been very weak (see next chart). The yen has depreciated from 115 yen to the U.S. dollar at the start of the year to just 136 today. This renders it 45% undervalued according to one valuation metric. For its part, the euro has now touched parity with the dollar, its weakest valuation since the early 2000s.

Euro and yen fall to lowest level against U.S. dollar in 20 years

As of 07/22/22. Source: Macrobond, RBC GAM

This movement has happened for two main reasons:

1. Fear and risk aversion are creating a thirst for safe-haven assets, of which the U.S. dollar features centrally.
2. Rate differentials are building.

The U.S. is tightening monetary policy much more aggressively than in the Eurozone and Japan. It is no coincidence that the Canadian dollar has largely held its value versus the U.S. dollar given that its monetary policy trajectory is proving similar to the U.S. (relatively strong commodity prices also haven’t hurt).

This trend should reverse at some point – the dollar is now overvalued versus the euro and yen – but not necessarily just yet. Any resolution will likely be in synchronization with an enduring revival of risk assets.

What does a stronger dollar versus weaker euro and yen imply? All else equal, the U.S. should be running a bit less inflation than otherwise, and the other countries should be running a bit more.

U.S. corporations are already reporting worse overseas earnings given that the exchange rate is working against them. Conversely, Europe and Japan enjoy a substantial boost in their relative competitiveness versus the U.S.

For foreign investors, U.S. markets have been relatively stronger than for dollar-denominated investors. To U.S. investors, the rest of the world’s markets appear to have performed even worse than they truly have.

In the case of Japan, the Bank of Japan seems quite comfortable with its weaker exchange rate and stronger inflation (now up to +2.3% YoY). Both suit Japan’s needs at the present – the former to help address relatively sluggish Japanese growth, the latter to (hopefully) drive nails into the coffin of Japan’s long experience with deflation.

Fiscal odds and ends

Windfall taxes

Windfall taxes are one-time or temporary taxes imposed on a corporate sector, usually after the sector has enjoyed unusually strong profits.

These seem to be regaining popularity. Canada imposed such a tax on its banks in 2021. The U.K. recently announced a windfall tax on oil and gas companies, with the funds directed toward ameliorating the cost of living for U.K. households. Today, energy companies around the world walk on pins and needles for fear that a windfall tax could strike them during this period of unusually high profits.

We flag these windfall taxes as there is the real risk of more given large fiscal deficits and a volatile economy that sees some sectors thrive as others struggle. Policymakers have already been tilting policy in a less business-friendly direction.

Windfall taxes are concerning for investors and businesses. Unpredictability is not good in the tax space, and may motivate the re-allocation of capital – and businesses themselves – to other jurisdictions.

U.S. fiscal policy

With a bare-bones majority of one vote in the U.S. Senate, the Democrats continue to struggle to deliver their next economic package. Holdout Senator Manchin recently made clear that he will not support any legislation with a tax increase or significant environmental measures.

On the tax front, this means that the long-promised U.S. corporate tax hike is now unlikely to happen before the midterm election this fall. It’s even less likely to happen in the two years afterward given the high probability that the Republicans claim at least one chamber of Congress.

Global minimum corporate tax

Further, the proposed global minimum corporate income tax also now appears unlikely in the near and medium term. Not only is the U.S. no longer in a position to pass its portion of the tax, but Hungary appears similarly disinclined despite pressure from both the EU and the U.S.

Fiscal drag, demonstrated

We have long mentioned that fiscal policy is exerting a subtle drag on economic growth in 2022, if hidden behind more grandiose headwinds such as rising interest rates, the resource shock and high inflation. The following three charts – for the U.S., Canada and the U.K. -- illustrate the idea (see next three charts).

U.S. fiscal deficit ballooned as a result of the pandemic

As of June 2022. Source: Macrobond, RBC GAM

Canada’s federal budget balance improving, but still deeply in the red

As of March 2022. Source: Department of Finance Canada, Macrobond, RBC GAM

U.K. federal budget balance has shrunk since re-opening

As of June 2022. Source: Office for National Statistics (ONS), Macrobond, RBC GAM

While fiscal deficits are still large today, the point is that they are much smaller than they were one and two years ago, and there is still room for them to shrink further. A shrinking fiscal deficit, loosely, implies that governments are spending less money than in the past. That’s a subtraction from economic activity.

Avoiding fiscal temptation

A final fiscal thought: it is critical that governments not become too generous with their fiscal support as the economy weakens. To be sure, automatic stabilizers should be allowed to activate and no doubt some additional support will be provided to especially beleaguered groups.

But it would be a mistake to lard on the support with anything approaching the enthusiasm of the past two years. This would just undermine the entire purpose of monetary tightening: to cool the economy to the point that inflation pressures cease to be self-perpetuating. If large-scale fiscal stimulus were delivered, central banks would have to raise rates even further and/or inflation would take longer to come down.

China’s economic whiplash continues

China recorded a horrendous second-quarter GDP performance of -2.6% versus the prior quarter (-10.8% annualized). But real-time data has since argued that the country then staged a significant rebound as COVID restrictions waned (see next chart).

Subway traffic in major Chinese cities rebounds

As of 07/21/22. Index is the weighted 7-day rolling sum of subway trips in Beijing, Guangzhou, Nanjing, Suzho and Zhengzhou. Source: Chinese metro agencies, Macrobond, RBC GAM

Now, Chinese COVID-19 cases are beginning to rise again. Major economic centres such as Shanghai figure less centrally into this latest wave. However, a number of provinces are affected and recording a hundred or more new cases per day. There is every reason to think that Chinese lockdowns will manage to quell these, but at some further economic cost. Chinese growth is set to remain underwhelming.

Another case of whiplash originates from the Chinese housing market. China has famously had major housing market problems over the past year, with a sharp decline in construction activity and the near-insolvency of several major builders, including Evergrande.

Some metrics of housing activity had appeared to begin rising in late June. However, that now appears to have been an illusion induced by the end of lockdowns, which released a brief surge of pent-up demand and production.

Activity is again weakening, and, worryingly, a subset of Chinese home buyers are going on a mortgage payment strike. These home buyers purchased new homes over the past few years, but the homes have yet to be constructed by builders (China’s housing market is unusual in that people pay for the house – and thus obtain a mortgage – long before their homes are built). Approximately 10% of Chinese properties under construction are thought to have been suspended – a high number, though not actually any higher than the level reached in 2019. Incredibly, Nomura estimates that around 40% of Chinese properties presold between 2013 and 2020 were never completed.

Analysts fret that this strike – already representing around 4-5% of mortgage debt in the country – could result in additional defaults by borrowers, and put strain on the Chinese banking sector as well.

Chinese counterpoints

But it isn’t quite all bad for China. The government is delivering stimulus, including an increase in infrastructure spending for the third quarter of the year. Shanghai has a 50-point plan to revive its economy. Local governments will also be allowed to sell an additional US$220 billion in bonds – an action that traditionally drives the housing market higher.

The government has cut its quarantine period for international travelers from two weeks to one, while some cities have scaled back their COVID testing policies. Perhaps China will have a slightly softer touch in future waves.

Inflation remains high

In the U.S., the Consumer Price Index (CPI) has leapt to +9.1% YoY – a 40-year high. Canadian inflation now reads +8.1% YoY. On a month-over-month basis, U.S. CPI in June was the hottest it has yet been this cycle (see next chart).

U.S. CPI monthly trend remains high

As of June 2022. Source: U.S. Bureau of Labor Statistics (BLS), Macrobond, RBC GAM

However, there is good reason to think that the July month-over-month print should be somewhat cooler. The main reason is that commodity prices – including, crucially, gasoline prices – have declined during the month.

Inflation peaking?

More generally, our inflation peaking scorecard continues to argue that something has indeed changed over the past few months (see next table). Whereas previously the vast majority of indicators were pointing to inflation rising, some are now turning and many are wavering.

U.S. inflation peaking scorecard suggests a change is on the way

As at 07/20/22. “Turning” identified using mix of M/M and Y/Y methodologies. “Pandemic-boom goods” is used vehicles + sports vehicles (including bicycles). Source: RBC GAM

Within this, it is particularly notable that real-time inflation measures based on online prices are now flattening out and even beginning to tentatively fall for a wide range of developed countries.

There is, of course, no guarantee that inflation declines steadily from there. Future commodity price movements may be depressed somewhat by the prospect of a weaker economy, but that tidy thesis could yet be undermined by Russian actions or other surprises. There have been many of these in recent years.

A particular X-factor is the extent to which the remarkable breadth of high inflation starts to narrow again as consumers become more price sensitive and less willing to tolerate rising prices, especially in products for which the underlying cost has not increased. The U.S. Federal Reserve’s recent Beige Book found that around half of the Fed’s 12 districts cited customers pushing back against higher prices.

In our view, the inflation question is less whether it is peaking – likely ‘yes’ as the four big drivers all simultaneously turn (supply chain problems, the commodity shock, monetary policy and fiscal policy) – and more where it goes after peaking. It could remain problematically high for many months to come. Alternately, it could politely decelerate over the ensuing months. Our bet is some deceleration, but not necessarily to normal readings with any haste. We anticipate a fair amount of choppiness along the way that will occasionally obscure the downward trend.

When is inflation no longer a problem?

It is tempting to say that central banks and markets won’t feel entirely comfortable until year-over-year inflation is truly and sustainably back to the realm of 1-3%. But surely it won’t take that long before the panic button can be released.

The initial hint of inflation problems being resolved will be monthly prints that aren’t quite as high as before, though still much higher than normal. July should deliver one such month, along with the question whether a few of these can be strung together without help from artificial factors.

A stronger signal will happen when month-over-month inflation readings ease, without being entirely normal. When they are back to rising by 0.2-0.5% per month, that will still be more than is ideal, but will constitute a significant improvement from the current trend of around +0.8% per month. Even if inflation were to transition down to this level over the span of the next few months, the end-of-year annual number would still look quite ugly: around +7.5% YoY in December for the U.S. This is an important point: markets and central bankers could be quite confident that inflation is on its way back to normal well before the annual numbers admit it.

An extremely strong signal will be when month-over-month inflation readings are fully back to normal, recording prints in the realm of +0.0% to +0.3% per month. But we warn again that the year-over-year reading will likely still be fairly elevated at that point. It will deceive more than it informs given the amount of stale data it contains.

Lastly, there can be no doubt when the annual reading is back down to +2.0% YoY, though central banks and markets will have long known that inflation was vanquished by that point.

Money supply growth slows

We do not tend to be monetarists, meaning that we believe the rate of growth in the money supply is far from a perfect predictor of inflation. Nevertheless, it is a positive sign that as central banks engage in quantitative tightening, this is becoming visible in the form of a shrinking money supply (see next chart).

U.S. M2 begins to turn downward

As of May 2022. Source: Federal Reserve, Macrobond, RBC GAM

Wages not a second-round driver of inflation?

Inflation-adjusted wages are down sharply over the past year (see next chart). An inflation fear is that workers could demand large wage increases to make up for this shortfall. This would result in businesses that continue to raise their prices in response to higher labour costs even after the original drivers of high inflation have faded.

Real wage growth in U.S. has dropped significantly

As of June 2022. Average hourly earnings of production and non-supervisory employees. Source: U.S. BLS, Macrobond, RBC GAM

This may well happen, but it is less likely than commonly imagined. That is because inflation-adjusted wages are not actually below their trend level, despite the recent trauma. Instead, real wages grew substantially faster than normal during the early stages of the pandemic, with recent weakness merely representing a return to the prior trend. So, no additional “catch up” is strictly needed, at least at the aggregate level (see next chart). It is fair to concede that real wages will soon fall below the trend line if nominal wages don’t accelerate further or inflation doesn’t decelerate, but the point is that the mismatch is not as enormous as is assumed.

Inflation-adjusted U.S. wages are still in line with pre-pandemic trend

As of June 2022. Source: U.S. BLS, Macrobond, RBC GAM

Economic indicators continue to weaken

The twin Institute for Supply Management (ISM) indicators in the U.S. both fell. The S&P Global services measure unexpectedly declineding below the 50 threshold in July – the traditional delineation point between a sector’s growth and decline. The ISM manufacturing survey’s new orders minus inventories metric has now fallen into significant negative territory (see next chart).

U.S. businesses continue to report growth, but deteriorating

As of June 2022. Shaded area represents recession. Source: ISM, Haver Analytics, RBC GAM

Meanwhile, the Eurozone’s manufacturing PMI index has now fallen to 49.6 – consistent with mild contraction. The new orders component has fallen even further into contraction, recording just 42.6.

Other indicators

The consensus growth forecast continues to fall in nearly every country surveyed, while the inflation consensus continues to actively rise in every country we examine. Our own forecasts have been reliably below the consensus with regard to growth and above the consensus with regard to inflation, and thus ahead of the game. That said, we are beginning to lose our zeal for above-consensus inflation forecasts as evidence mounts of inflation peaking.

U.S. businesses are not feeling optimistic about the economic outlook. The National Federation of Independent Business’ survey on the subject has been plummeting, now falling to a record low (see next chart).

U.S. small business expectations for economic outlook at record low

As of June 2022. % of firms that expect better business conditions less % of firms that expect worse business conditions six months from now. Shaded area represents recession. Source: NFIB Small Business Economic Survey, Macrobond, RBC GAM

In addition to tentative evidence of weakening hiring and capital expenditures, businesses are reported to be paring back their digital advertising. This is a reflection of economic considerations and also privacy changes made to phones that render such advertising less effective.

Housing continues to weaken across the developed world. Construction activity is starting to be affected. In Canada, home prices are falling significantly. We are inclined to pivot from our base-case forecast of a 10% national price decline toward something closer to our negative scenario of -25%.

Tentative consumer weakness

Of the three real-time consumer spending measures we track, two continue to behave roughly normally, while one is weakening. But even the normal readings are considerably softer than initially imagined when one adjusts for the high rate of inflation.

It is a similar situation with more traditional measures of consumer spending. U.S. retail sales and real consumer spending, when adjusted for inflation, have been anemic to outright weak (see next chart). People are spending more money, but not getting more things.

U.S. consumption starts to ebb

As of May 2022. Source: U.S. Bureau of Economic Analysis (BEA), U.S. Census Bureau, U.S. BLS, Macrobond, RBC GAM

We wonder whether consumer spending and economic activity in general could weaken suddenly after the summer. After a long pandemic and a difficult winter, people are trying to maximize the pleasure they derive from this summer – via any number of means, including pecuniary – with the view that the fall and winter could be less pleasant from a pandemic perspective. If this thesis is true, there could be a sharp drop-off in economic activity in September.

Recession signals

We continue to flag the high risk of recession for most of the developed world. In the U.S. context, our new recession scorecard finds that five of the 10 major signals now forecast a recession. A further three indicate ‘likely’ or ‘maybe.’ Just two of the 10 say ‘no,’ and they are steadily ratcheting their way toward ‘yes’ as the yield curve flattens (see next chart).

Recession signals tilting toward ‘yes’

As of 07/15/22. Analysis for U.S. economy. Source: RBC GAM

Among these inputs, our own RBC GAM recession model now assigns a 61% chance of a recession over the coming year (see next chart). We actually suspect the probability is higher, as evidenced in part by the fact that every other time the probability has been assigned anywhere near that level, a recession has subsequently ensued.

The probability of U.S. recession within a year

As of June 2022. Based on RBC GAM model which includes financial and macro factors. Shaded area represents recession. Source: Haver Analytics, RBC GAM

Supply chains improve

Supply chains are improving, if imperfectly. This is important, as supply chains have been one of the main drivers of high inflation. Additionally, the Bank of Canada estimates that supply chain disruptions have subtracted as much as 2.5% from the level of supply.

The latest sign of amelioration is that the demand for computer chips is easing. Recall this has been a particular pinch point for the electronics and motor vehicle sectors. The price of memory chips is declining significantly, with a further decline anticipated over the coming quarter. The price of graphics chips are estimated to have dropped by half since January, admittedly in part because cryptocurrencies have imploded.

Tellingly, Intel just froze its hiring and Nvidia is scaling back its hiring plans. Micron Technology now forecasts sales for the third quarter that are a fifth lower than it had previously expected. Some companies are thought to have over-ordered computer chips given prior shortfalls, and so could scale back their future orders.

There is even the risk of overproduction as governments now subsidize new fabrication plants and companies respond to the strong demand of the past few years. Amazingly, 15,000 new semiconductor companies were formed in China in 2020 alone.

Of course, as these constraints on the supply of goods fade, the limitations on certain services grow. Case in point, Heathrow Airport is now limiting the number of passengers its airlines are allowed to circulate through the facility, requiring the cancellation of many flights. Elsewhere, other airlines have reached similar conclusions of their own volition, cancelling flights for capacity reasons. But we don’t expect service-sector constraints to prove as problematic as the goods-sector constraints they replace.

Rate hikes continue

The U.S. Federal Reserve appears set to raise rates by another 75 basis points this week, with a 100 basis point increase an unlikely but conceivable scenario. The Bank of England is set to follow next week with a 25bps or 50bps rate increase of its own.

Central banks have certainly erred on the side of tightening more rather than less recently. The Bank of Canada surprised nearly everyone with a giant 100 basis point rate hike, versus the 75 basis point move that had been expected. The European Central Bank (ECB) moved by 50 basis points, whereas 25 basis points had been expected not long before.

In Canada, this takes the overnight rate to 2.5%, with further tightening expected toward a peak of approximately 3.5%. Notably, the Bank of Canada emphasized that the additional tightening constituted a front-loading of policy rather than an additional rate hike. The end goal hasn’t changed: it is just the timing of the tightening that has been accelerated.

Incidentally, the last time the Bank of Canada raised its policy rate by 100 basis points in one fell swoop, in August 1998, the situation could not have been more different. Inflation was quite low and the rate hike was intended to restore confidence in Canadian financial instruments. Amid the Long-Term Capital Management crisis and Asian financial crisis, Canadian bond yields were rising out of line with the underlying policy rate and the Canadian dollar was depreciating. The rate hikes succeeded in attracting investors back to Canada and the central bank was actually able to cut rates a month later. None of this applies to the present situation.

The ECB uttered much the same sentiment about front-loading policy as Canada. Markets still look for a peak policy rate in the realm of 1.5%, even after the larger rate hike. It is a most welcome development that the ECB has now escaped the realm of negative rates after a long eight years.

The ECB also formalized its new Transmission Protection Instrument (TPI) for shielding peripheral sovereign debt from undue bond market pressure. The theoretical contours of the instrument are actually quite restrictive. They apply only when bond-market pressures are “unwarranted” and prevent assistance when a country is out of compliance with the EU fiscal framework or when there are severe macroeconomic imbalances or bad macro policies within a country. That said, in practice and with a bit of fudging, the instrument likely suffices for dealing with the sort of pressure that is occasionally applied by markets to Greek and Italian debt.

Smoothing

Why is it that when central banks say they want to raise their policy rate to 3.5%, they don’t do it all at once, but instead proceed in measured steps? The answer is that there can be damage to the economy and financial markets when they go too far, too fast. Borrowers and businesses alike need time to adjust to an altered interest rate environment.

When central banks say they are front-loading policy, they are really just reducing the amount of smoothing in the equation. This does some damage, but offers the advantage of getting policy to its optimal point faster. Speed is of the essence right now.

-With contributions from Vivien Lee, Andrew Maleki and Aaron Ma