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“Now the drugs don’t work, they just make you worse…“

The Verve, Drugs Don't Work

Last week, we discussed the significant event risks that were held by this week. With US CPI and the trifecta of DM central banks to close the activity for the year. Ultimately, we argued that as growth cools, it becomes much more complicated for Central Banks to gauge what the Fed (and as of this month, the ECB) describe as “sufficiently restrictive” especially given that as demand slows, it potentially does so in a non-linear manner. Today we reflect on this week’s central bank meetings and discuss the added complexities of differing dominant components of inflation across the UK, Eurozone and US and the implications for monetary policy in 2023.

All animals are equal, but some are more equal than others.


The November CPI data provided some additional evidence that slowing demand and easing supply chain issues for various goods are starting to impact pricing. Last month Powell highlighted the three categories that combine to define US inflation trends: (i) goods prices - where there are already signs of significant declines (falling another 0.5% in November); (ii) housing related services - rents and other housing measures that are likely to be in a more prolonged uptrend due to lags and other technical reasons and; (iii) non housing related services - largely reflective of business’ labour costs and the key focus of the Fed.

Headline CPI for November, released on Tuesday, came in below expectations at 7.1% y/y (Est. 7.3%, down from 7.7% in October), with core also below expectations at 6.0% y/y (Est. 6.1%, down from 6.3% in October). This faster than expected deceleration is significant. Indeed, at the headline level it is becoming clearer that overall price momentum is decelerating and within that the breadth of the spread of individual components that are experiencing outsized price gains is declining and; the momentum of the inflation category that the Fed are most closely watching (non-housing services) is also falling.

Going into the FOMC, the Wall Street Journal ran a story from Fed Whisperer, Nick Timiraos, that suggested that this ‘slowing inflation could intensify the Fed debate about when to stop raising rates’ - explicitly framing the debate about further trimming the active policy increment to “a more traditional quarter percentage point”.

On Wednesday, the Federal Reserve delivered a 50bps hike, to raise the target Fed Funds Rate (FFR) to 4.25% -4.50% with just one change to the statement (other than the target FFR itself) being a technical adjustment to the wording around the Russia/Ukraine conflict and its effect on inflation. The lack of change in the statement is significant in the fact that some commentators had anticipated the replacement of the term “ongoing” as a description of “appropriate” increases to the FFR, with “further” - a subtle change but one that would have beeen indicative of an FOMC closer to the end of its hiking cycle.

The median Fed ‘dot’ for 2023 - taken by the market as a barometer of Fed expectations for the terminal rate in the current cycle - given their explicit pledge to hold rates in restrictive territory once achieving a “sufficiently restrictive” level of rates as part of their forward guidance - was raised by 50bps to 5.125% (or a target FFR of 5.00% - 5.25%, from 4.50% - 4.75% at the September FOMC). That said, the projections also show bigger cuts in 2024 and Powell emphasised again that the dots are not debated and do not represent a projection or commitment from the FOMC.

Not only were the median dots higher, but so too were the inflation forecasts, with the 2023 PCE projection raised to 3.5%. However, while some commentators looked at this as a hawkish iteration from the Fed, we are more inclined to view this as a function of the change in the baseline level of inflation between the time of the September projections and that of the December projections (as was intimated by Powell at the press conference) - We still view the direction as the most important factor.

Overall, we remain less inclined to view inflation as persistent in the US - certainly less than the market consensus. The declining inflation, and the encouraging inflation progression across all three of the components highlighted by the Fed are all in all good news for the economy. What is also good news for the Fed is that ultimately the core driver of inflation in the US is excess demand, and thus is more likely to be responsive to monetary policy (with a lag). It is even possible that the most positive outcome for the economy and for risk assets is a short period of negative growth - shaking off inflation (through a non-linear demand shock?) and facilitating a return of the FFR to neutral (2.5%?) or even below.

Lastly, as inflation does fall, as we expect through 2023, front end real rates are going to become even more restrictive. Thus, as inflation falls, the rate at which the Fed may consider “sufficiently restrictive” also falls. I would certainly not rule out the possibility that the March FOMC meeting (after a 25bp hike in Feb), will be unchanged as new projections highlight the lower inflation and demand profiles!


Anyone who was anticipating a relatively dull ECB meeting (me included) got this wrong. Despite the protestations of Mme Lagarde, the December ECB meeting did, in my opinion, represent a significant pivot - Hawkish, not Dovish!

While the 50bp hike was widely expected and priced by the market and the QT announcement was also in line with expectations - the inflation projections, and the resolute inflation fighting stance of the ECB took markets by surprise. The ECB revised up its inflation projections throughout the forecast horizon and most notably in the the first projection for 2025 where headline inflation is expected at 2.3%, and Core inflation at 2.4% – This means that the ECB projected path of rate hikes and the Market expectations of rate hikes are NOT enough to get inflation back to target at the forecast horizon, by some margin. Indeed, Lagard inferred that the ECB could well hike rates by 50bps in four consecutive meetings and despite this, they expect core inflation to still be more than double the target (4.2%) at the end of 2023 - a worrying prospect for growth, for bonds and for peripheral yields.

Amid the significance of the adjustments to the ‘active’ monetary policy tool (the deposit rate), the focus on the announcement of the ECB’s plans to reduce its APP asset holdings (QT) were largely a sideshow. Especially as a function of the fact that they will not begin until March 2023 and when they do they will occur as a function of curtailed reinvestments of around EUR 15B per month.

An awkward combination of more persistent inflation (bouncing back in H1 through food and wage price pressures), and weaker growth, albeit with a growth backdrop that is expected to be supported by a strong labour market, gives Europe a bad or uncomfortable growth/inflation trade off, just as eurozone members announce increased issuance next year to pay the energy bills!. Risks remain that the ECB monetary tightening does little to arrest the exogenous price pressures (except perhaps through the currency channel by supporting the EUR), but has a significant, damaging impact on growth.

The BoE

As we discussed last week, “the UK has the negative energy shock of the eurozone as well as the stimulus demand shock of the US, and the Labour supply shock of Brexit”. In short, the UK faces a pretty ugly period of uncertainty and an ugly or complicated growth/inflation tradeoff. Indeed this uncertainty was highlighted by the extraordinary spread of opinion on the Bank of England's Monetary Policy Committee (MPC). Last week we suggested that it could be a 4-way split in the vote - the only reason we didn’t get this was that Swati Dhingra was more dovish than expected, joining Sylvana Tenreyro in voting to keep policy unchanged on the basis that 3% is more than sufficient given the weakening economy.

It is historically unprecedented that with two members dissenting in favour of unchanged, against a Governor proposal of +50bps, that another member, Catherine Mann, should dissent in favour of 75bps - citing risks of more persistent price pressures.

For choice, we would favour the growth weakness beginning to weigh on demand and thus prices more clearly in Q1 causing the reaction function of the MPC to moderate. However this would likely require the tentative signs of some ‘covid retirees’ returning to the workforce in this week’s employment report (an easing of labour market tightness) to continue if such growth weakness were top result in easier MPC policy projections.

In short

In short, it seems that the ECB are determined to fight a persistent, if exogenous inflation shock with tighter policy – The Fed have the luxury of the fact that their inflation is driven predominantly by domestic demand and thus as the economy slows so too will inflation - it is not the same for the ECB. Indeed, the Fed has the added solace in the fact that it has a dual mandate - price stability and maximum employment - therefore it perhaps has more leeway to consider the growth dynamic in its policy settings.

At the start of 2023 we could very well see the Fed hiking 25 and signalling a pause, while at the same time the ECB hiking 50 and signalling a continuation at that pace - effectively a differential borne out of the underlying components of inflation (domestic demand vs. exogenous energy shock). While ultimately, a more chronic demand shock (recession) will bring eurozone inflation lower, the near term narrowing of rate differentials should be a positive for EURUSD in Q1 and beyond. The BoE and GBP are likely to be stuck somewhere in the middle.

This morning we discussed the analogy of central bank interest rate rises as either antibiotics aiming to protect the economy from the problems of inflation, or even rate cuts as being steroids for economic growth (and potentially inflation). However, perhaps the biggest problem is that currently facing the ECB, when whatever the drug, they don’t work, they just make you worse!

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