There's been a lot of market talk in the past couple of weeks about the Bank of England, with the notion that their decisions makers might be committing to a policy error.

THE CURRENT DILEMMA OF CENTRAL BANKS

• Central bank policies of extremely low rates and quantitative easing have created inflation in the real economy (not just asset prices)
• The problem is that the global economy is now used to very low rates, with high levels of leverage almost everywhere
• So here's the dilemma: although it's clear that hiking rates will have a negative impact on the economy, price stability is one of the mandates of central banks (the only mandate in fact for some).
• In this economic version of Sophie's choice, different central banks are taking different approaches: some will kill inflation at all cost, others find it convenient to pretend that high inflation could be "transitory" (even for a few years).

WHY A POLICY ERROR THEN

There are many mistakes central banks can make, and we will focus on two that are relevant today:

1. Waiting too long to normalize rates: keeping rates very low for so long that temporary inflationary pressures become permanent: sticky things like rents or wages start embedding high inflation, and it becomes very hard to take it out of the system (like in the 1970s).

2. Raising rates too soon and too fast, thereby causing economic damage and having to quickly reverse the policy.

At the moment, the first scenario is not of great concern to markets (inflation curves are inverted steeply), but many markets (including the UK and the US) have started to price in the second type of policy error.

EURO AND GBP MONEY MARKET CURVES

• Looking at the chart at the top of the page, EURIBOR markets expect the ECB to be loose for a long time without causing crazy inflation, but they expect the BOE to walk into the second policy error described above
• The 3-month EURIBOR futures curve shows rates staying low for a long time, and moving up gradually to a slightly higher rate in 2025 (barely above 0)
• The 3-Month GBP LIBOR forward curve by comparison prices in a fairly brutal policy normalization: the rate rises by over 1.15% in a little over a year and hikes are basically expected to be done by the end of 2022. Designed to kill inflation, they actually prove too difficult for the economy to adjust to. As a consequence, after a while policy makers decide to reverse their policy and rates are expected to go down again. In other words, Sterling money markets are currently considering the second type of policy error as their central scenario.