2022 was the year of peak inflation. 2023 the year of peak interest rates. 2024 could be described as the year of peak politics, with seven of the ten most populous nations going to the polls.
Thus, politics and geopolitics may never be far from the focus of markets, but at the start of the year attention has been more on monetary policy stances and in particular the speed and scale at which inflation and policy rates may fall in the US.
Through this year, three themes look set to dominate: financial conditions, heavily influenced by central bank policy decisions; the outlook for economic growth; and the political and geopolitical landscape.
First, financial conditions.
The start of the year has seen the market moderate its expectations regarding the speed and scale of rate cuts, led by the US Federal Reserve. That makes sense. While policy rates look set to fall this year, easing may be later and more gradual in the US, euro area and UK.
The markets are in danger of receiving another jolt in the coming week, as there is a possibility the Bank of Japan (BOJ) will tighten at their policy meeting. The markets expect no change at this policy meeting but I would not be surprised if they act. Any move will be small, consistent with the BOJ’s policy to date of a gradual exit from its ultra-loose monetary policy.
Policy rates in Japan are currently -0.1% and yields are kept low under its yield curve control. Governor Ueda has made clear the direction of travel as the BOJ becomes more confident it can reach its 2% medium-term inflation goal. Last year saw recovery in Japan, fears of deflation replaced by expectations of a move towards 2% inflation, a stronger equity market, a weaker yen and a gradual monetary tightening. This year could see a repeat of all these.
The timing of the BOJ’s exit strategy highlights how domestic factors, as opposed to global drivers, will be important in gauging central bank policy actions this year. This is particularly so in those countries where central banks had adopted more prudent policy in previous years, such as across Latin America or Asia. In December, Chile for instance cut rates by 0.75%, while Brazil eased again by 0.5% with its Selic policy rate down to 11.75%.
Earlier this week the People’s Bank of China (PBOC), meanwhile, kept policy rates unchanged. In December, China’s annual rate of inflation fell 0.3%. The markets had for some reason expected a policy rate cut. With credit growth weak, I would expect reserve requirement ratios to be eased.
While domestic factors suggest more nuance and divergence in policy decisions, the policy outlook overall should be constructive for markets this year, allowing some easing in financial conditions across most countries.
One challenge, as we are seeing, is that at the end of last year markets had discounted aggressive rate cuts, led by the US, but to some extent followed by the euro area and the UK. But in these places, it is likely that easing may occur later and be less than the markets expect this year.
It is worth repeating a point made previously, that when the inflation environment changes, not only are forecasters, and thus in turn markets, slow to adjust but they assume inflation will return to its previous norm. This happened to some extent in the early 70s but was also evident in the early 90s. Likewise now, the expectation is that inflation will return to 2% in western economies.
Inflation is decelerating – as the previous supply-side shocks have corrected and tight monetary policy feeds through. But, in terms of where inflation settles, some of the global factors that have contributed to low inflation have weakened. Hence it may be plausible to factor in inflation at a slightly higher rate in future years, but that will still be relatively low, say 3% versus 2%.
Geopolitics could lead to a risk-premium being added to oil prices at various times during the year. As the Bank of England’s latest monetary policy meeting minutes noted, while commenting on external factors, “Domestically generated inflationary pressures in most advanced economies remained elevated and could yet keep headline inflation above central bank targets for some time.
There was also a risk that developments in the Middle East could lead to a renewed rise in energy, and potentially other traded goods, prices. Such a shock would push inflation higher once again, and could interact with inflation expectations and lead to second-round effects.”
Let’s consider the UK, where I think monetary policy has tightened too much. Policy rates are at 5.25%. I think they should have peaked at 4.5%. The latest retail sales figures for December reflect the weakness of the UK economy. Sales volumes fell 3.2% and this was the largest monthly decline since January 2021. While I believe that UK policy rates should fall to 4%, I expect them to be cut to 4.5% this year.
While the trend of UK inflation is down, the markets were spooked by inflation news this week which showed that the annual rate rose, from 3.9% in November to 4% in December. This unnerved the markets, as it was seen as dampening down the chances of a rate cut. It hasn’t changed our read of the inflation situation. There could always be another blip, but by May inflation should be very close to the 2% inflation target.
While decelerating inflation will be positive for the economy, it is important to appreciate the extent to which the price level has risen. Take UK food prices as an example. Food price inflation hit a 45-year high of 19.2% last March. By December it had decelerated to 8%.
As the Office for National Statistics (ONS) noted, “Although the annual inflation rate for food has been slowing, food prices are still high following relatively sharp rises over the latest two years. The overall price of food and non-alcoholic beverages rose by around 26% over the two years between December 2021 and December 2023. This compares with a rise of around 9% over the 10 years between December 2011 and December 2021.”
Against this backdrop one of the standout issues as this year progresses may be a debate on where the new neutral for policy rates will be. Pre-pandemic, western central banks thought r* (the neutral level for real policy rates) was close to zero. So 2% inflation would mean 2% policy rates and 3% inflation would mean 3% policy rates.
Perhaps they may now concede r* should be higher. If they accept that it should be 1% then inflation settling at 3% might imply 4% policy rates. Rates need to settle at a higher level for longer than compared with the recent past. This does not mean rates need to stay at current levels. Higher for longer is still consistent with policy rates being cut this year from their current levels.
However, the reaction of markets towards the end of last year suggested they did not fully buy into this idea of rates settling at a higher level. There is still a perception, it seems, that policy rates could yet be cut to very low levels again. Expectations about the speed of rate cuts may have to adjust to central bank behaviour.
Weak global growth
The second key theme this year is modest growth. This, too, should be constructive for markets. Some, if not all of this has been discounted by markets towards the end of last year, as a fall in inflation will boost real incomes and help economic recovery, while some easing in policy rates will ease financial conditions.
Last year highlighted the resilience of many western economies, particularly the jobs market, including the US and UK, in the face of aggressive monetary tightening. Despite this, the UK and euro area still ended 2023 on the verge of recession.
Also, and importantly, last year pointed to decoupling across Asia. Thirty years ago the worry was that Asia would not cope if Japan (which was then the biggest regional economy) slowed, and it did. More recently the fear has been whether Asia would cope if China slowed. Last year suggested it might.
So modest, but far from strong, global growth looks likely this year, helped by monetary policy easing. On the IMF’s measure, growth may prove to be higher than previous expectations, perhaps around 3.2% versus 3% last year.
Already this year the World Bank’s new forecasts point to modest growth. They use a different measure to the IMF and expect global growth of 2.4% versus 2.6% last year and 6.2% in 2022 after the post-pandemic rebound. They noted this would mean growth in 2022-24 was weaker than surrounding the Asian financial crisis in the late 1990s and the 2008 global financial crisis.
The current state of the global economy leaves it vulnerable to shocks. Of these, contagion from the existing wars in Ukraine and Israel-Gaza would be the biggest fears.
A year of elections
That leads into the third main issue which is politics and geopolitics. We have already seen this in the last week alone.
With the aftermath of the Taiwan election where the DPP won the presidency for the third time and while that eased market worries, cross-strait tensions will persist.
There was former President Trump’s victory in the Iowa caucus. Polls point to Trump winning the Republican nomination and also show him beating President Biden in the six key states of Arizona, Florida, Georgia, Michigan, North Carolina and Pennsylvania. But lots can happen, and we will return to likely future policy.
And the latest opinion polls pointing to a change in government in the UK, where elections are likely this year.
Seven of the ten most populous countries in the world face elections this year: India (through April and May); China (no); USA (5th November); Indonesia (with the first round of the presidential elections on February 14th and if needed a second round on 26th June); Pakistan (8th February); Nigeria (no); Brazil (no); Bangladesh (has already hosted it in January, and while PM Hasina was re-elected the elections were boycotted by the opposition); Russia (15th-17th March) and Mexico (2nd June).
For now, it is central bank policy that is at the forefront of market thinking. And this year, the focus will be on financial conditions and how much they will improve in the face of policy easing, modest economic growth plus political and geopolitical risk.