The world’s leading central banks talked hard this week but carried a smaller stick.
After a series of meetings on Wednesday and Thursday, the Federal Reserve, the European Central Bank and the Bank of England all decided to change their anti-inflation strategy to half a point from a recent pattern of interest rate hikes of 0.75 percentage point. Switzerland, Norway, Mexico and the Philippines also slowed the pace of rate hikes.
However, they married weaker deeds with stronger words. The Fed spoke of having “more to do” to beat high inflation, the ECB spoke of “building more ground” while the BoE insisted it must act “firmly” against inflation.
These movements were anything but coordinated. Instead, the world’s central banks are trying to buy room for further rate hikes if they deem it necessary at a time when apparent peak inflation in many countries could complicate this further politically.
Seth Carpenter, who spent 15 years at the Fed and is now Morgan Stanley’s chief global economist, says most central banks are nearing their benchmark rate hikes, which is likely to result in a sharp slowdown or recession in their economies. As a result, he said proposing more action now was a smart strategic move.
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“Central bankers really have the responsibility for macroeconomic stability,” he says. “So I think they’d rather be wrong by talking tough and saying they’re willing to keep raising rates and then happily finding out later that they didn’t have to do more than telling the world they are done and then say, ‘Oops, we have to do more.’”
Falcon forecasts
The Fed was the first to move on Wednesday, breaking a series of four 0.75 percentage point hikes and completing a half-point hike, leaving rates now in a target range of 4.25 percent to 4.5 percent.
The unanimous decision to slow the rate of increase has been accompanied by restrictive forecasts and rhetoric. A new set of economic forecasts signaled officials’ intent to raise interest rates to just over 5 percent next year with no rate cuts until 2024. “Unacceptably high” inflation.
“We have achieved a lot and the full impact of our rapid tightening so far is yet to be felt,” he told reporters. “Nevertheless, we still have more to do.”
In Frankfurt, interest rates are still significantly lower than in the US at 2 percent, but ECB President Christine Lagarde insisted the smaller rate hike than in previous meetings was not a shift towards the end of the tightening cycle, as it appeared.
“The ECB is not backing down,” she said, adding that the euro-zone central bank “has more ground to cover, we have longer to go” than the Fed. Its near promise of further rate hikes of half a percentage point in February and March surprised economists, many of whom had expected the central bank to quickly end its cycle of interest rate hikes in the coming months.
Firefighters in the city of Vyshgorod, north of Kyiv, are putting out a fire at the scene of Russian shelling. Inflation and growth depend on the course of the war in Ukraine in almost all countries © Efrem Lukatsky/`
In Britain, where the authorities now enjoy less international standing than during September’s disastrous mini-budget, the Bank of England hiked interest rates for the ninth straight meeting to 3.5 percent, the highest in 14 years. BoE Governor Andrew Bailey stressed the move was prompted by further evidence of inflation feeding into private sector wage increases. This, he said, “justify[d] another forceful monetary policy response”.
Although the original causes of high inflation differed in the eurozone, UK and US, economists pointed out that all three central banks face the same difficult communication challenge for 2023.
Headline inflation has almost certainly peaked and will fall next year, but officials are by no means certain that underlying inflationary pressures will also disappear. They fear that it will take too long for inflation to return to its hoped-for 2% target and that it could remain at a much higher rate.
Some of the concerns about future inflation in Europe relate to the time it will take for the energy shock of 2022 to fully work its way through the economy.
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All three central banks fear domestic service sector prices could continue to rise sharply in still tight labor markets, where wages are rising at rates they say are consistent with the 2% inflation target.
Given this difficult challenge for the next year, the financial markets have struggled in recent days to interpret interest rate decisions and announcements from central bankers.
They found the ECB’s message the easiest to interpret. Lagarde’s words were much more aggressive than expected and “prompted the biggest market reaction,” according to Philip Shaw of investment firm Investec. The benchmark S&P 500 fell 2.5 percent on Thursday after bullish comments came from the ECB.
Krishna Guha, Head of Policy and Central Bank Strategy at US brokerage firm Evercore-ISI, says: “I take Lagarde at his word when she says the ECB will continue to hike aggressively.” Like many analysts, Guha said after Lagarde’s comments on Thursday revised its forecast for the likely peak of the ECB’s deposit rate to 3.5 percent from 2.75 percent.
In contrast, many investors on Wall Street are either questioning the Fed’s determination to keep raising rates or are betting that the Federal Reserve will flinch at the first sign of real economic distress. Despite Powell’s protests on Wednesday, traders in the federal fund futures market reiterated their bets that the federal funds rate would peak below 5 percent next year and that the central bank would cut rates by next December.
“The market isn’t buying it,” says Tiffany Wilding, North American economist at pension fund manager Pimco.
The reversal will happen faster than some people still seem to appreciate and I think this will probably be the case for most central banks around the world
Complicating the Fed’s message is the fact that Powell on Wednesday did not specifically rule out the Fed again cutting rate hikes and implementing a quarter-point hike at its next policy meeting. The British markets also interpreted the measures taken by the BoE as slightly cautious and scaled back their expectations of future interest rate hikes.
The main question hanging over these mixed market reactions is the likely underlying strategy of central banks in 2023 when headline inflation falls.
Many economists believe that policymakers want to act aggressively before inflation falls enough and economic conditions become too difficult to explain further rate hikes almost impossible.
Dario Perkins, global macroeconomist at TS Lombard, a consulting firm, says tough talk about monetary policy is part of the game central bankers are playing to exercise caution in wage negotiations and company pricing, saying they “have a Incentive to play up recession risks” because it helps to ease inflationary pressures.
But a large group of economists also fear that the hawkish tones from central banks are real and that policymakers will go too far and trigger a deeper recession than officials want or think is necessary to tame price increases.
For example, many ECB observers believe that the Frankfurt institution was too pessimistic on inflation and too optimistic on growth in its latest forecasts this week, leaving it at risk of raising rates too much.
Carsten Brzeski, head of macro research at Dutch bank ING, says the ECB could be forced to withdraw its plans for an aggressive rate hike once it finds “its forecasts for the eurozone economy are overly optimistic”.
Tom Porcelli, chief US economist at investment bank RBC Capital Markets, takes a similar view of the Fed. “The reversal will happen faster than some people seem to appreciate, and I think that’s likely to be the case for most central banks around the world,” he says. “You have the major economies, all of which are either on the brink of recession, on the verge of recession, or already in recession. You don’t have to be a big tea leaf reader to see what’s coming in the not too distant future.”
Covid-19 tests are carried out at a street stall in Shanghai. The success of China’s move away from a zero-Covid policy and its impact on inflation are being closely watched by central banks © Alex Plaveski/EPA-EFE/Shutterstock
These divergent views between those who say central bankers are showing reasonable concern about lingering inflationary risks and those who believe the hard messages are real and overblown show how difficult it is to assess the economic outlook for 2023.
Both inflation and growth in almost all countries depend on the course of the war in Ukraine, which will affect energy prices, the success of China’s move away from a zero-Covid policy, the uncertain impact of interest rate hikes already implemented and the risk that households and businesses will tighten their belts when a downturn hits and make it significantly worse.
The BoE is already fond of using the word recession to describe the UK’s outlook, warning that the current slowdown could be prolonged. While the ECB talks about the possibility of a “short and shallow” recession that will only last for the next few quarters, the Fed’s Powell says there is no telling if the US will slide into a recession. A soft landing is still possible for the US economy.
Central banks have not had to defeat a serious inflationary spurt in 40 years, and few are confident they know whether officials have done too little, enough or too much with interest rates to ensure they can restore price stability to advanced economies.
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