Last week, we discussed the latest monetary policy decision from the Bank of England - a three-way split (unchanged, 25bp hike and 50bp hike: highlighting the complexity of the UK’s growth/inflation trade-off), resulting in the consensus acceptance of the Governor’s proposition, a 25bp hike, taking the Bank Rate to 5.25%. However, we also highlighted the clear dovish pivot in terms of the accompanying statement (and MPR) - a leaning which was echoed throughout the press conference. Most significant was the amply repeated statement that the current policy settings are in restrictive territory - “Given the significant cumulative rate increases, the stance is now restrictive… there is clear evidence that the rate is having an impact”. We argued that this was a significant new evolution.

Not only did the MPC highlight the restrictiveness of current policy settings, but they also introduced the concept of time, as well as magnitude in the (re)construction of the policy guidance. This is essentially linked to the lagged effects of previous cumulative rate hikes, a factor that we expand upon further below. Ultimately, the reference to “different paths to achieve the same end” infers that the prospects of rates being held in restrictive territory for a significant period would likely have the same impact as the market path of rates that implies further hikes, then cuts. This is, from our viewpoint, both significant and dovish, relative to market pricing.

On the growth front, the MPC accepted that there had been more mixed data and that future policy activism would be ‘evidence driven’ (not a million miles from the ECB’s ‘data dependence’). Forecasts show increasing economic slack next year. While the inflation projections in the near term were revised higher, and thus growth lower, the projections continue to see inflation significantly below target at the forecast horizon (with a very significant reduction in the upside skew to inflation risks). Markets continue to price further rate hikes, but this is likely to become increasingly moot in our view.
Last week, we also touched on the volatility in the US rates curve, after the US rating downgrade by Fitch and the Treasury refunding schedule (higher issuance), and even some more complicated debates about whether equilibrium rates, and thus long yields, have moved structurally higher - all of which ultimately pushed term yields higher.

This week, the big focus has been the US CPI print for July and the implications for US monetary policy. The CPI print came in below expectations for the second consecutive month, this time with the headline rate lower than expected and the core in line (with expectations that were revised lower earlier in the week). Core CPI posted the smallest back-to-back gains in over two years on a monthly basis, driven by softer than expected core goods. Car prices and airfares continued to drag and rents and OER continued to normalise. The data did however show that nine tenths of the increase in overall CPI was due to housing costs which are widely expected to continue to decline through the rest of 2023. All in all, a supportive number for our long-held disinflation bias.

The inflation print came amid a wider market debate (and seemingly also at the Fed) about the lags of monetary policy and thus the implications for the forward Fed Funds path and by extension for bonds, currencies, and risk assets. Shorter policy lags would imply a greater proportion of the impact of previous (cumulative) hikes have already impacted demand, thus increasing the argument for further hikes to restrain demand and prevent a prospective inflation rebound. Long lags, the opposite.

From our perspective, the huge pandemic fiscal stimulus (and ongoing significant fiscal deficit) in the US likely imply longer lag time, as excess savings have delayed or damped the impact of tighter monetary policy in the near term. The recent full erosion of excess savings at the low end of the income spectrum and significant erosion in the middle are likely an important case in point. Furthermore, the impact of higher rates in and of themselves (let alone the lag with which they occur) is long lasting - likely so too the impact of higher nominal prices. These factors likely add downside growth risks to the macro composition.

At the July FOMC meeting, the Fed’s Chair was very clear that rates are in restrictive territory (as the BoE also emphasised last week). Furthermore, in the Q&A, his response to a question about whether or not the Fed would continue hiking until inflation got to target is significant - “...so the idea that we would keep hiking until inflation gets to two percent would be a prescription of going way past the target. that’s clearly not the appropriate way to think about it ... because, you know the federal funds rate is at a restrictive level now. So, if we see inflation coming down credibly, sustainably, we don’t need to be at a restrictive level anymore. We can move back to it, to a neutral level, and then below a neutral level at a certain point ... and you’d start cutting before you got to 2 percent inflation.”

One key reason for this, and a point that we have argued as significant for a number of months now, is that as inflation declines, real rates become even more restrictive. From our perspective, while there are downside risks to growth, we do not think that an acute recession is likely in the near term (as underlying growth is supported by an already negative output gap, strong labour market, fiscal expansion and corporate investment through CHIPS, IRA and Infrastructure Acts). However, now that the risks to inflation are becoming balanced, the emphasis placed on relative shifts in growth expectations likely have a greater impact on monetary policy expectations. Indeed, in the US and the UK, broader growth rates are now likely the dominant data sensitivity for market reaction functions in terms of yield curve pricing.

This week may have been all about inflation from a data perspective, but for us the dominant focus for policy expectations is fast becoming growth. Recent rhetoric from Fed speakers and the ECB has been more balanced about the prospect for potential further rate hikes and thus incrementally dovish. Signs that growth is faltering, however, likely turn talking into walking!