The three major central banks have started 2023 in a similar vein to 2022, but markets seem to think we’re about to turn the corner…
The Federal Reserve (Fed) was the first of the three big central banks to meet, and as we’ve often seen with the Fed, it didn’t disappoint; the rise of 25bps had been well signalled, and brought the Fed Funds target range to 4.50-4.75%. The committee was unchanged in its view that ongoing increases in the target rate are appropriate, a somewhat contrasting view to the market, where expectations have adjusted downwards, such that only one further hike of 25bps in March is being priced in. This may in part be due to the markets concern about Powell’s discussion around the disinflationary process, as well as the declining economic backdrop.
On inflation itself, the statement was fairly balanced, acknowledging that inflation had eased, but remained high, and warned that the longer inflation remains elevated, the greater the risk that it becomes entrenched. In line with the more recent shift towards data dependency rather than forward guidance, the Fed remains focused on incoming data between now and March to determine just how high rates might peak. In our view, the Fed still remains concerned about not doing enough to tackle inflation, than about hiking too far.
Financial markets are much more sanguine about inflation and are focusing on the weaker economic data. They have assumed that interest rates reach a peak below 5%, with rate cuts then coming as early as Q2 this year. This led to a sharp steepening of the US yield curve following the Fed decision and a ‘risk-on’ environment for equity markets. One should always remember the mantra 'Don’t fight the Fed'….and I am not quite sure that Fed Chairman Mr Powell is finished quite yet.
European Central Bank
At its February Monetary Policy meeting, the European Central Bank (ECB) delivered on its well-flagged 50bps hike across its three key interest rates and went one step further than perhaps the market had expected by confirming its intention to do the same in six weeks’ time at its March meeting. From that point, it stated that it will then evaluate the subsequent path of its monetary policy. It reiterated its view that rates need to be kept at restrictive levels over time to reduce inflation, by dampening demand and guarding against a persistent upshift in inflation expectations. The ECB also confirmed its commitment to start its balance sheet reduction program in March, initially at a pace of €15bn per month, to be achieved by not fully re-investing the maturity proceeds of bonds bought under its Asset Purchase Programme.
Despite this affirmation of its intentions to continue tightening policy, the market rallied significantly on the announcements and continued to do so, seemingly latching on to the glimmer of hope that the ECB won’t be able to deliver on its intention to raise by a further 50bps in March. When questioned on this in the subsequent press conference, ECB President Christine Lagarde commented that whilst the intended March hike was 'not irrevocable', at this stage she could not think of a scenario where they would not deliver on the pledge. Lagarde went still further with the hawkish messaging stating that hiking rates was not enough and that they would have to stay there for a considerable period of time to ensure that inflation is returned to target.
So who is right? The European central bankers who believe that whilst the battle on inflation may be being won, there is still a way to go, or the market, who are pricing in policy errors, in the belief that inflation has been tamed and the ECB will be forced to loosen policy far sooner than it has pledged? Time will tell, but on the immediate price action after the ECB, it seems that the market is really testing the resolve of the ECB to follow through on its commitments.
Bank of England
At yesterday’s Bank of England (BoE) meeting, the committee raised UK base rates by 50bps to 4%, in line with consensus. Having raised rates at every meeting since December 2021, taking base rates from a record low of 0.1% to the current level of 4%, it is hard to argue against the prevailing narrative that the BoE might be nearly done. The economy has been weakening, very high spot inflation has been rolling over, and there are signs that the labour market might be starting to soften too. The BoE stated that further ‘forceful’ action on rates is no longer required in order to bring inflation sustainably back to its 2% target and is now forecasting inflation to fall to 1.4% by the end of 2024, before weakening further in 2025. So, having raised rates by 390bps in 14 months, the BoE is clearly closer to the end of the cycle than the beginning. But it continues to reiterate the fight is definitely not over.
The BoE remains nervous about the persistence of core inflation, and any additional second round spill over effects into wages, particularly given labour markets remain tight. Despite the Governor stating that the risks to inflation were significantly skewed to the upside it’s not all doom and gloom on the economy. The BoE took a sledgehammer to some of its November headline grabbing projections – rather than forecasting one of the longest recessions in history, it now expects one of the shallowest ‘recessions’ in history, with a peak to trough fall in growth of just 1%. It also expects the unemployment rate to remain below 5.3%, which is significantly below the 6% level it forecast as recently as November.
This narrative is in complete contrast to the picture being painted by the UK bond market. It has paid very little attention to the notion that the BoE remains nervous about inflation being more sticky and persistent, and that it might need to pause or perhaps hike rates further. Markets instead are declaring that the UK’s fight against inflation is well and truly over, rate cuts are coming – and aggressively, beginning as early as Q4 2023. With such a shallow recession, such a low peak in unemployment, and inflation still uncomfortably high, the markets may be sipping that over inflated champagne a little too early!
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