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Central banks’ surprising pivot

15th Dec 23 11:23 am

The US Federal Reserve (Fed), the Bank of England (BOE) and European Central Bank (ECB) all decided to leave interest rates unchanged at their policy meetings this week. That was expected.

Unexpectedly, however, the Fed endorsed the market’s recent thinking that rates will fall next year. While we, too, had been factoring in rate cuts next year, with gradual easing, we like the market had expected Fed Chairman Powell to be more hawkish at this latest meeting. Instead, he signalled a bias towards easing – albeit not immediately. But a cut as early as March is now possible, and even likely.

These three central banks have retained a hawkish tone in recent months that has reinforced their tighter stance, while economic data was pointing to inflation decelerating and to growth slowing. Indeed, the euro area is in recession, the UK economy is stagnant and the US has been losing momentum, although appearing for now to be heading towards a soft landing.

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The conclusion to be drawn before the Fed’s shift this week was that policy rates had peaked, although there would be monetary tightening via balance sheets being shrunk via quantitative tightening.

But the issue was between pause versus pivot. The communication was that rates would be on pause for some time – largely because core inflation had proved stickier and it was uncertain where inflation would settle, even though it was decelerating.

While the messaging was directed towards a pause, the markets were discounting a pivot, with rates expected to fall gradually next year. Crucially, though, this week the Fed has endorsed the focus on when rates will fall. The next issues will be when, by how and where to? In particular, where will neutral rates be? The issue of where neutral is will likely be an ongoing issue in the new year, but for now US financial markets will be buoyed by the prospect of rate cuts.

The Fed’s messaging

Let’s focus on the Fed, which as noted, left policy rates unchanged at its December meeting – at 5.25% to 5.5%.

A Summary of Economic Projections (SEP) is released four times a year. These are the collated views of each individual member of the FOMC. Although they are forward looking they are not a plan and don’t always tie the Fed’s hands at subsequent meetings.

There was a marginal change in the SEP between the last FOMC forecasts from September and now, in terms of the collective outlook for growth and inflation. Both are expected to be marginally lower next year. In September, the median view from the SEP pointed to growth of 1.5% next year; this time the forecast was 1.4%. Likewise, with the PCE measure of inflation: from 2.5% in September to 2.4% now.

In contrast, there was a significant shift in expectations for policy rates. In September the projection for the Fed funds rate next year was one rate cut to 5.1%. The latest showed a drop to 4.6%, suggesting three rate cuts in 2024. The comments from Powell at the press conference that followed did not rebuff such market views, and instead reinforced such thinking. The SEP also signalled policy rates of 3.6% at the end of 2025 and of 2.9% at the end of 2026.

A year ago, financial markets were too pessimistic, expecting a recession this year. But, as Powell acknowledged, the economy looks set to grow around 2.5% in 2023, although he also noted its recent slowdown.

Importantly in the US, and often unremarked upon, fiscal policy has played a vital role. In contrast, it has not done so in the UK or the euro area. In the US, the rebalancing of policy towards a tighter monetary and looser fiscal stance has helped the US to enjoy a soft landing, with inflation easing, growth slowing but not collapsing and the labour market, to use Fed Chair Powell’s words, “moving back into balance”.

Powell’s initial comments at the press conference were not aimed at being dovish, stating that inflation is still too high and its future path was uncertain. He also stated that while rates were at or near their peak they would be “prepared to tighten further if appropriate”.

However, as the press conference progressed, the Fed Chair came across as relatively dovish. Most interesting was his comment that the Fed wouldn’t want to wait until inflation reached 2% to ease and would act well before 2%. Having been behind the curve in tightening, it is clear that the Fed does not want to fall into that trap again in terms of easing.

His comments indicated that the Fed was aware of the risk of being behind the curve and of the risk of keeping rates too high for too long. It does not want to make that mistake. The Fed has also moved from the price stability mandate being pivotal to both mandates of price and employment stability being important.

The Fed’s focus is on the data, the outlook and the risks. All three are now consistent with the case for easing monetary policy. The danger for the US is if the soft landing enjoyed so far becomes a hard landing, with the economy falling into recession. Whereas only a few weeks ago it gave the impression that its fear was that inflation may be reignited if policy is eased too early.

And perhaps fearful of this changing picture and of economic slowdown, Powell and the Fed have indicated that rates are set to fall next year. As here in the UK, the full impact of monetary policy tightening in the US has yet to feed through fully. That is a concern and will weigh on the economy. But importantly, US financial conditions have eased significantly in recent weeks and will ease further in the wake of this latest FOMC meeting. This, alongside the likelihood of interest rate cuts next year, should allow the US to avoid recession.

In contrast, the UK economy is stagnating. The economy contracted 0.3% in October and was flat in the three months to October. The euro area, meanwhile, is in recession. It contracted in the third quarter by 0.1% and latest indicators suggest it will be in recession in the fourth quarter, too, thus delivering a technical recession.

Also, in contrast to the Fed this week, the BOE’s Monetary Policy Committee voted 6-3 to leave rates unchanged at 5.25% at its December meeting; with three members voting to hike. Given this, it is probably premature to rule out completely the possibility that the BOE could hike again, although in our view that is not necessary and indeed UK rates have probably risen too far.

The UK still has persistence in core inflation in a number of items and we may yet see a temporary rise year-on-year in January 2024 data if firms seek to pass on higher costs. Notwithstanding that, UK inflation should decelerate until next summer. In the wake of the Fed’s meeting the market is now speculating that UK policy rates will fall to 4% by the end of next year. That seems too much.

Before the Fed meeting the market had expected the BOE to ease to at least 4.75% and possibly 4.5% by the end of next year. That seemed right. In our view rates have risen too far and growth is slowing.

Whereas the Fed has pivoted, it may be best to view the BOE and ECB as being on pause. But it would not be a surprise if the change in thinking that has impacted the Fed will be seen in the UK and euro area, too, as we move through the early part of 2024.

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