Central banks should favor market inflation expectations when setting policy - UBS

Central banks should prioritize financial market inflation expectations over consumer and corporate surveys when determining their monetary policy, according to UBS. The global oil benchmark, Brent crude futures, has surged by over 71% year-to-date following the U.S.-Israeli attack on Iran in February, causing an inflationary shock.

This has forced central banks like the European Central Bank to raise interest rates. In the U.S., the consumer price index (CPI) rose by 3.4% year-over-year in August, while the producer price index (PPI) increased by 5.4% in the same period. Both of these figures contribute to the Federal Reserve's preferred inflation gauge, the personal consumption expenditures (PCE) price index, which has been above the Fed's 2% target for 65 consecutive months.

UBS chief economist Paul Donovan emphasized that financial market participants have realized that inflation expectations are significant, but warned that central bankers must be cautious not to overemphasize them. Donovan stated that expectations only matter if they result in a change in economic behavior. He argued that investors' inflation expectations are more influential because they possess greater power to act compared to consumers and companies.

This could lead to different inflation expectations between investors and borrowers, which may impact investment. Donovan concluded that central banks should focus on financial market expectations when setting policy, disregarding inflation expectations from consumer and corporate surveys.