Last week we discussed the evolution of the monetary impulse in developed markets this year. We reiterated our view that the Fed hiking cycle was much closer to the end (if not already there) than analysts and markets alike were implying. Indeed, we continued to point out our view that many commentators were focussing too much on the relative evolution of prices, yields and inflation on the implied monetary cadence and not the absolute level of prices and yields and their implications for inflation.

We continued to argue that we see inflation declining significantly through 2023 and that this factor, along with the fact that we see the tightness in the labour market as being asymmetrically biased to the low end of the wage scale suggest that current monetary policy settings can become ‘sufficiently’ or even excessively restrictive, even without further rate hikes if inflation falls, as we expect.

Lastly, we argued (as we have consistently done for months) that the risks to demand are, in fact, to the downside and non-linear, due to the negative wealth effects in the middle-income distribution (as described in previous pieces) the erosion of the excess pandemic savings (especially at the low end of the income scale, offsetting the labour market tightness) and even now, as we have seen in recent days, a likely increase in lending standards, that threaten to tighten financial conditions and reduce lending capacity in the real economy.

In short, we argued that we increasingly believe that DM rates have already reached their peak.

This week, we have seen modest rate hikes from the FOMC and the BoE and while in both cases there was - as you would expect, given the primacy of the inflation target, in both instances - the caveat of a resumption or extension of the hiking cycle should inflation persistence continue. Both intimated that they were closer to the end of their hiking cycles than the market pricing. I think they are done.

The Fed hiked rates 25bps to a 4.75% - 5.00% target range, in line with the adjusted market expectations following the recent small bank funding stresses that have been the dominant driver of market sentiment for the past couple of weeks. However, from our perspective there we three factors to focus on:

(i) The Statement and the press conference prioritised the narrative around the significance of the current banking stress and the role of the Fed (to provide financial as well as price stability). Essentially, highlighting the fact that “Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation”. While the press conference outlined the Fed had clearly discussed a ‘pause’, the view that deposits had stabilised, likely gave the Fed more confidence to deliver on expectations for the March meeting - albeit with the extraordinary caveat that quantifying the banking impact on the economy at this stage would be ‘guesswork’.

From our viewpoint this may well be a statement that comes back to bite Chair of the Fed- if this week’s rate hike aggravates the small bank funding (or wider banking) sentiment further, Fed’s Chair may legitimately be asked whether further policy tightening should have waited until it was no longer ‘guesswork’. Broader markets may align with our current view - not just that rates are already ‘sufficiently restrictive’ but that the most recent hike may well have been a step too far!

(ii) On growth, the Fed’s Chair highlighted that nearly all participants saw growth risks weighted to the downside, in addition to the fact that the economic projections were revised lower - GDP estimates for both 2023 (despite the strong start to the year in some high profile data series) and 2024. However, what we found most interesting was the explicit reference from the Chair of the Fed at the press conference that recessions tend to have non-linear implications for growth and for inflation - a point of concern that we have been highlighting for many weeks, particularly through the housing channel which the Fed’s Chair described as “weak” - indicative of a more cautious Fed going forward.

The Fed are still expecting growth to remain positive (if below potential), but if inflation falls back (as we expect) and growth moderates, real rates will begin to push higher, more restrictive.

(iii) By extension the statement language was amended to reflect the reality of a shallower rate hike path (if at all) from the current level, with the section of the statement “The committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time” replacing ‘ongoing increases’ with ‘some additional firming may’ be appropriate. The Chair of the Federal Reserve even used the press conference to emphasise the carefully chosen ‘some’ and ‘may’ - to highlight the uncertainties. Indeed, the Chair of the Fed even stated that he thinks that it is likely that financial conditions have tightened more than traditional measures/indices might suggest at this time.

The Bank of England offered a similar, cautious narrative as it too raised rates 25bps, taking Bank Rate to 4.25% in the face of rising uncertainty. The MPC voted 7-2 (with dissent from committee members who continue to argue that rates are already sufficiently restrictive and underlying growth is likely weaker).

There were a couple of technical adjustments that make the Bank more comfortable with a higher rate path: a) Near term economic outlook appears stronger than expected, with employment growth more resilient - in no small part due to the boost from energy price declines. b) Budget measures will raise GDP by 0.3% according to the Bank - as savings from the energy price cap are redistributed and c) Real incomes will remain flat (not fall rapidly) as inflation is expected to fall back sharply due to the energy price cap extension.

Indeed, in some respects it could be argued that the statement was relatively hawkish on balance with the pledge for more rate hikes should inflation show signs of persistence. However, The BoE forecasts expect inflation (and to a lesser extent growth) to fall sharply over the rest of the year. However, subsequently and potentially with the aim of softening the inferred inflation hawkishness from earlier in the day, Governor of the Bank of England offered a more balanced tone. “We Have Raised Interest Rates a Lot Already… We Believe Inflation Will Fall Quite Rapidly Before the Summer”. On balance, we believe that the Bank have done enough.

While the picture is not so clear from an incremental (macro data) standpoint, from an absolute perspective, rates, prices and credit are very tight in the UK and as asset price declines start to impact consumer sentiment and aggregate demand negatively, we feel that the non-linear downside risks very much apply to the UK too. I expect that the next move from the BoE is lower, not higher.

Above-target inflation, for now, likely means that central bankers adopt a hawkish narrative. Aimed at anchoring inflation expectations. Aimed at preventing rate cut expectations from loosening financial conditions more than central bankers are comfortable with. However, over coming months we expect inflation to fall back sharply, credit conditions to remain tight as banks prioritise funding over credit creation, and consumer sentiment to come under pressure as the lagged effects of tight monetary policy and high prices (as pandemic savings and revenge spending erode) start to hit aggregate demand. This prospect has material implications for rate markets, as we are now starting to see adjust.

Ultimately, we believe we have seen a clear change in the path from the Fed as they acknowledge the impact of recent bank stress (tighter credit conditions) - The risk is that they have realised this too late. Joining all the dots we believe this is consistent with a Fed (and BoE) that is open to the prospect that they are already done on rates. We think they are.

Some might say, it is now more likely to be growth and not inflation that will “hold sway over time.”