In recent decades, investors have become accustomed to very benign central bank tightening cycles. However, history suggests that there are two very different cycles with very different implications for markets. Ethan Harris, Global Economist at Bank of America, the analogy between “good cop “and the” bad cop“to explain the historical difference between the two periods.

Harris speaks of the “good cop” to refer to the central bank that intends to normalize the rates and backtracks if there are signs that the market or the economy “can’t take it.” Rather, the “bad cop” is the central bank deliberately trying to cool down the economy (and markets) as a way to fight unwanted inflation.

“Today, most central banks play good cop. However, in hotter economies a little more law and order may be needed,” Harris says in a report distributed to his clients.

In this sense, it indicates how for a long time, markets have not experienced a hard central bank in the developed world. Proof of this was evident during the recovery after the financial crisis. The Bank of Japan never raised rates while the ECB briefly experimented with higher rates in 2011 before backing down from the eurozone debt crisis. The Fed tried to slowly normalize rates between 2015 and 2018, raising the price of money by 225 basis points for a period of three years. However, its current president, Jerome Powell, was forced to back down.

That said, for Harris, it’s important to draw the right lesson from this episode. The Fed started raising rates because it expected core inflation to return to its target. Instead, core inflation stagnated. And what is even more revealing, there was a steady decline in expectations inflation, both in surveys and in the market.

In this context of weak inflation, the Fed stopped raising rates at the first sign of weakness in the economy. Even cut rates by 75 basis points in 2019 when the risks of an economic slowdown appeared. Shortly thereafter, the pandemic struck, ending any concerns about inflation.

Currently, in the face of rising inflation, investors have advanced the Fed’s rate hike schedule and now wait 2 or 3 climbs in each of the next two years. However, the market seems to be aiming for a terminal rate of 1.5%, more or less, and anticipates that there will be no increases in 2024.

According to Bank of America this limit is too low for three reasons. First, with higher inflation, the central bank of The US has to go higher to reach the neutral real rate. Second, going up late should mean going higher to compensate for the additional overheating of the economy. Lastly, the Fed will respond very differently to weaker growth if inflation is a problem.

Harris stresses that history suggests that sometime next year the Fed will have to change gears. “If inflation sits close to the expected overshoot, it can go from an extremely moderate attitude to a slightly aggressive attitude,” he warns. On the contrary, if inflation settles above the expected excess, “they will have to become much more aggressive. This would imply accepting a natural correction in the markets and the economy or deliberately inducing such a correction, “he adds.

The ECB will not repeat the mistakes of 2008 and 2011, when it raised rates prematurely

The Bank of America economist believes that the Federal Reserve will warn markets well in advance before raising rates. However, once the Fed gets going, it is likely that raise rates faster than the market expects.

Beyond the Fed, the risk of a currency calibration error also grows for other central banks. In Europe, Rubén Segura and his team at Bank of America consider that the ECB will not repeat the mistakes of 2008 and 2011, when he raised rates prematurely. However, they are concerned about a premature withdrawal from asset purchases. Other central banks, especially in emerging markets, will try to keep up with the Fed to prevent capital flight. Finally, some of the stronger economies, such as Canada, might find that they also have an inflation problem.

The Fed is set to reduce its purchases this year, according to central bank minutes