“Rising up to the challenge of our rival“
Survivor, Eye of the Tiger
Last week, we discussed the impending central bank decisions - the final monetary guidance for 2023 - set against the rapidly evolving market sentiment from a macroeconomic perspective. We highlighted the fact that in Europe, while the growth trajectory has been in question for a significant period (not least since the Russia/Ukraine/Energy crisis brought into question the sustainability of the German industrial model in the absence of cheap imported natural gas), the November inflation readings across Europe (missing to the downside across the region) had driven a sharper repricing of the European yield curves and weighed on the EUR. Essentially, markets were pricing ECB rate cuts for 2024 earlier and faster than the Fed. We stated that this seemed - and still seems unlikely to us.
Furthermore, last week we argued that while the inflation data for November was clearly and significantly lower than expected, it is not clear to us that markets should at this stage be extrapolating an accelerated decline in either inflation or growth. Growth and inflation will likely be supported by positive real wage growth. We stated: “Essentially, we would expect the ECB to be very hesitant to back or validate market pricing of a potential ECB rate cut as soon as Q1 next year. Indeed, while it is likely that the updated projections from the Governing Council lower growth and inflation projections at the front end, it is unlikely that recent developments were significant enough to change the projections at the forecast horizon. In our view, the market is a little ahead of the ECB.”
This week, developed market central banks were front and centre. Before continuing with the ECB, it is likely important to set the stage with the Fed.
The Fed left the target rate unchanged at 5.25% - 5.50% as widely expected, with a statement that was broadly unchanged from the November meeting (also unchanged). The subtle changes that were made to the statement however were iterations that emphasised the proximity to the peak of the cycle (the addition of ‘any’ to the sentence ’any’ additional firming needed) and also emphasised the further disinflation and growth moderation (“growth of economic activity has slowed… inflation has eased over the past year but remains elevated”). Both in our view dovish iterations and a nod to the attainment of peak policy restrictiveness.
The real focus however was on the forward guidance, or the updated Summary of Economic Projections (SEP’s) and the dots (or projected forward rate path of the Members). The projections showed that the ‘median’ dot indicated 75bps of rate cuts in 2024, facilitated by lower growth and inflation projections in the SEP’s (to 1.4% and 2.4% respectively) - more than the 50bps that was implied by market pricing going into the meeting.
Furthermore, after the dramatic yield sell-off across the US curve seen since the start of November, markets had anticipated some pushback at the pace of rate repricing in the US curve from Chair of the Fed. This did not happen. For a long while now we have had a strong view that we will see continued disinflation in the US, with growth moderation, but still growth (‘a hard landing for inflation, but a soft landing for growth’). The December FOMC was the first time the Fed had so clearly inferred this direction in their broad thinking. We have some further thoughts:
In the press conference Fed’s Chair highlighted their three stages of monetary policy framework (i) How fast to move (in combating inflation), (ii) How high to raise, and (iii) When is it appropriate to dial back policy. Chair of the Fed was clear that the Fed are currently in stage (ii). However, he was also explicit that the Fed “discussed the timing of rate cuts at this meeting” and that they would “want to reduce restrictiveness well before 2.0%”. This is important in light of the recent data, which has shown lower than expected readings and Fed’s Chair even noted himself that by some measures trend inflation is already at or near 2.0% - not much time therefore to cut well before hitting the target!
In addition to this Chair of the Fed made further reference to points we have discussed a lot over the course of this year - that the pandemic distortions to demand and supply were responsible for significant distortions to the inflation trajectory, not simply a period of natural excess demand. It remains unclear to us that inflation should remain sticky, or above the pre-pandemic norm. Indeed, we see little reason for the structural factors that kept global inflation so low pre-pandemic to have altered over the coming years. Chair of the Fed highlighted downside risks to inflation on this basis - “we kind of assume it will get harder from here - but so far it hasn’t”.
So with a much more dovish than expected Fed, markets were quick to price in extrapolated rate cuts, not just from the Fed, but also the Bank of England and the ECB. The Bank of England, however, proved things aren't always that simple.
The Bank of England remain caught in the most complicated growth/inflation trade off in DM with further signs of fragility in growth (despite continued relative tightness in the labour market) yet prices remain significantly above target. Indeed, set against this backdrop three MPC members continued to vote for a rate hike (Haskel, Mann and Greene), with a clear reference in the statement that there is “still some way to go in the inflation fight”.
The ECB were somewhere in between.
The market's expectations of an ‘extrapolated decline in growth and inflation’ in the eurozone as we outlined above were clearly disappointed. On inflation. President of the ECB was clear that although inflation had fallen considerably (more than expected and below the ECB forecasts in some instances) the Governing Council expect inflation to rise in December on base effects and to fall at a slower pace through 2024 (due to further base effects). Upside risks come from bigger than expected increases in real wage growth and higher than expected foreign demand (read China recovery?). She also said that the data we have now does not show wages declining – collective bargaining and, because they have evidence that wage rises feed through into higher prices of goods and services (absorbed by margins), price increases in the new year will be key.
On Growth ECB’s President was clear that near-term growth is subdued on foreign demand and rate pass-through into manufacturing and construction (rate sensitive sectors) but that the labour market continues to support the economy. Lastly, President of the European Central Bank also referenced the fact that the inflation projection curve is based upon the market pricing on November 23rd. At that point, the Curve was pricing 86bps of rate cuts in 2024. Thus, if we compare to the current 157 priced (pre-ECB) then financial conditions would be looser, growth stronger and inflation likely higher in the projections. Is the ECB reaction function thus even weaker – as far as cuts are concerned?
Going back to our earlier comparison between the Fed and the ECB rate path and the markets keen assumption that the ECB will cut before the Fed and by a bigger quantum (a supposition that we have continued to push back against). There were lots of questions on this at the press conference along these lines. President of the European Central Bank’s response. “Should we lower our guard on inflation? No. Absolutely not”.
For the BoE and to a lesser extent the ECB, the inflation fight is still on. The Fed, however, may have already risen to the challenge and gone the distance!
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Fed Minutes, 31st October - https://www.federalreserve.gov/monetarypolicy/fomcpresconf20231101.htm
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