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“I'm playing all the right notes… just not necessarily in the right order“

Eric Morecambe, The Morecambe and Wise Show, featuring (‘Mr Preview’) Andre Previn: 1971

Last week we discussed the Bank of Japan and its monetary policy evolution against a complicated global macroeconomic backdrop. As inflation shows further signs of peaking (and indeed decelerating) globally, so does global growth momentum - with the obvious exception of a faster than expected China reopening. The key question for central bank policymakers is to gauge the net impact on global aggregate demand and the likely balance of momentum of domestic consumption and inflation.

In the case of the Bank of Japan, the market is keen to price an abandonment of the YCC policy as core inflation is currently double the BoJ target. However, the BoJ is sticking to the mantra that it is not just the notes (the component parts of inflation) that are important, but also the order in which they are attained (wage inflation must be above core inflation for the BoJ - at least under current leadership - to consider such inflation sustainable.

This week has been very quiet, with Chinese Lunar New Year celebrations and Holidays and a shortage of first-tier global macroeconomic data ahead of an important data week next week. Geopolitics has also been front and centre, with the West's collaborative push to re-armour Ukraine ahead of the expected Spring offensives. So you could say that the focus has switched from Tigers, to Rabbits… to Leopards.

There have been a couple of important developments this week on the Central Bank front. First, Australia's stronger (if energy subsidy distorted) inflation print has extended expectations of the tightening cycle from the RBA. Though we remain at the dovish end of the spectrum in relation to Australia it is not yet clear how the China reopening demand and improved China-Australia relations will impact domestic inflation in the near term. The second is the Bank of Canada, who, after a record 8 consecutive rate hikes, stated that it expects to pause rate hikes while it assesses the impact of past, cumulative (425 bps) rate hikes.

Next week, alongside a return of some top tier data (US Employment report, industrial and services activity indicators and the January employment report) we hear from the Fed, the ECB and the BoE. We have some thoughts.


After a brief wobble earlier in the month (where ‘ECB sources’ supposedly indicated the prospect of stepping down active policy increment from March), ECB members, and indeed the ECB President have reaffirmed the intent and message of the December meeting that the Governing Council will deliver a 50bp hike in both February and March, before becoming more data dependent. Thus the decision next week is likely pretty clear as concerns about rising core inflation remains the dominant focus.

There are a couple of factors worth contemplating at this point. The pledge to hike a further cumulative 100bps in Q1 2023 will take the policy rate clearly into restrictive territory - with Chief Economist Philip Lane referencing ECB estimates of the neutral rate at around 2.0% and thus the prospect of further rate hikes in Q2 and beyond are much more moot, from our perspective. However, the current forecast rounds are seeing (and are likely to see) upgrades to Q4 2022 and 2023 on the basis of an unexpectedly mild winter (thus a vastly different energy price trajectory then feared) and an unexpectedly rapid China reopening (and more substantial infrastructure support package alongside a regulatory u-turn in tech and education sectors). Factors that see eurozone growth upgrades at the same time as US growth downgrades (or increased recession concerns)

Furthermore, on a balance of payments basis, there have also been further EUR supportive developments. We have discussed on many occasions over the past year, the prospect that the historic structural capital outflows from the Eurozone as a function of negative nominal rates would be curtailed by the removal of the negative interest rate policy in the Eurozone. More recently, it has become clear that not only will there be curtailment of the structural outflows from Europe (into higher yielding FX hedged assets) but that the currency backdrop likely turns the flows in the opposite direction. For the first time in a decade US investors can buy German Bunds FX hedged and the net result is an approx 5.0% positive carry (FX-risk free and significantly above the risk free rate of US Treasuries).

A faster incremental rate hike pace, positive net growth revisions and a rate structure that attracts positive capital account flows all bode well for the EUR over coming months.


However, next week's core focus will undoubtedly be the FOMC announcement and press conference on Wednesday. The key to the FOMC discussion, where there is likely little risk of anything outside of a 25bp hike to 4.50% - 4.75%, is the increasingly more balanced trade off between inflation and growth.

On the growth front it will be important to gauge the extent to which the Fed acknowledge the slowdown in economic activity and any emphasis they may place in particular sectors or drivers of the economy in this regard. How confident are the Fed in their predicted base-line scenario of a soft landing - a slower (below equilibrium), but still positive, growth trajectory?

In our piece last week, we discussed further our thoughts on the prospects of a non-linear demand decline, or the prospects for much quicker demand drop than analysts, markets or even the Fed are currently contemplating. This week, I have read some interesting analysis that corroborates the view that excess savings brought about by the huge US stimulus package have now been fully eroded. Thus, we can expect the future demand impulse to be directly weaker as a result - especially following a significant increase in the cost of borrowing to maintain current consumption.

Further, while the recent housing data for December suggest that house buying activity remains relatively robust despite the sharply higher borrowing costs, house prices are clearly slowing. This is likely to have significant negative wealth effects going forward.

Lastly, in relation to the labour market, it is not clear to me that, given the stark differences in labour market tightness along the income distribution scale, that a one dimensional focus on the labour market, or unemployment rate offers a clean read-through to nominal demand growth. Essentially, the point I am trying to make is that the labour market is extremely tight at the lower end of the income wage scale. This is where most wage pressure has been (studies have shown significant real wage gains for the lowest quintile, but negative real wage gains for the highest!).

However, the middle income group has been increasingly squeezed on all sides (last week’s economist ‘incomes are rising in America, especially for the poorest’ highlights the boost for the poorest relative to the richest - but also relative to the middle!). My point is that the ‘Middle’ has not benefited from tax and subsidy support and has been hit hardest by the combination of inflation (negative real wage growth) higher borrowing costs and falling asset wealth. If this is the case, then I am skeptical that a tight labour market (as defined by the unemployment rate or other measures of demand for labour), implies rising, or even positive aggregate demand growth, or consumption. US growth likely remains vulnerable, at least in the near term.

As far as inflation is concerned we are more inclined towards faster near term declines as base effects, nominal price level effects (i.e. the refusal to pay a 40% premium - relative to 2019 - for a used car, or $1000 per night for a standard room in a big city hotel), demand decline and supply chain reinstatement implications for further manufactured goods prices.

Lastly, on inflation, there has been an interesting debate this week following a post from an economics professor at UPF Barcelona that the ‘instantaneous’ level of US inflation (i.e not an average of the price rises over the past year, but the ‘current’ level) is already back to the 2.0% target. The assumptions and validity (and even stability) of this can be discussed, but it is very clear that on a 6-month annualised and 3-month annualised basis, US inflation is sequentially significantly lower already. Are the Fed closer than they think to ‘sufficiently restrictive’? Our view remains that 25 in Feb and a pause in March is much a much more likely outcome than the market pricing.


The Bank of England likely has the toughest job of all. With potentially the weakest growth trajectory (as supply factors from the Northern Ireland Protocol issues to labour shortages and strikes), but the most stubborn wage and headline price pressures (as have been demonstrated in the most recent data). Markets are now pricing almost 100bps of rate hikes followed by 25bps of cuts - all this year! While we remain in the Tenreyro/Dhingra camp, that the current level of rates is ‘sufficiently restrictive (anecdotally the underlying strength of the economy feels very fragile to me), for the BoE, playing the right notes in the right order looks very complex.

As we await the important central bank meetings next week, all three will be looking to play all the right notes in the right order. However, as far as the policy mandates and divergent macro signals are concerned, the musical arrangements they are attempting to perform vary in difficulty.

Have you listened to Neil's podcast series?

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