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TD Securities’ James Rossiter argues that major central banks have shifted their reaction functions after recent supply shocks, now placing greater emphasis on inflation and expectations than on growth. The report suggests that Oil around $150/bbl would mark the point where demand destruction dominates inflation concerns, potentially triggering rate cuts rather than hikes in response to further energy shocks.
Higher Oil reshapes central bank reaction
“Recurring supply-side shocks in the last decade or so saw central banks pivot toward “flexible inflation targeting” (FIT), which allowed them to shift focus toward downside growth risks and away from “transitory” inflation shocks (effectively, a shift in the relative weights in their loss function).”
“The sizeable inflation shock from Russia’s invasion of Ukraine threw FIT out the window, and forced many central banks to rush to hike rates in 2022. Concurrent rapid fiscal support limited downside growth risks, meaning central banks could have looked through potential demand destruction and focused more on higher inflation. They did not.”
“We think that central banks have learned their lesson, to a large degree. Policymakers are now likely to put relatively more weight on inflation and inflation expectations than growth in their loss functions.”
“There is still a point for central banks at which demand destruction outweighs “transitory” inflation, justifying rate cuts instead of hikes in response to a supply shock. This point is further out now than it was in the last decade.”
“We think oil at around $150/bbl is where demand destruction begins to outweigh inflation fears for central banks.”
