‘Interest rates rise as expected, investors take fright’. This might have been a newspaper headline in recent days, but why did investors take fright at what was expected?
Investors had anticipated last week’s round of interest rate hikes, which saw the Fed, the Bank of England and the ECB all raise their benchmark interest rate by 50bps. For all, it was a deceleration after November’s 75bps hikes.
Against a background of weakening inflation and growth in the G7 economies, it makes sense for central banks to slow the pace of monetary tightening and so avoid inflicting unnecessary pain.
The Fed has an explicit mandate to promote employment (i.e., growth), as well as stable prices. Other central banks have an implicit obligation to keep an eye on growth, not least because killing the patient with an overdose of medicine defeats the purpose.
But two themes emerged from the central banks’ statements, the press briefings that followed and investors’ response.
Wage growth might prevent inflation falling to 2% target levels
The first was that the smaller rate hikes came with more aggressive warnings of the inflation problem at hand.
Although inflation looks set to fall in all the major economies over the coming months, it will take longer to fall than had been expected. Inflation is stubborn, increasingly reflecting tight labour markets and pay growth rather than external supply shocks such as energy prices. Economists fear that pay growth of, say 6% plus (as per the U.S. and the U.K.) will prevent inflation from falling to the 2% inflation target set by the major central banks.
This heightens the risk of an embedded inflation problem emerging that is traditionally more stubborn than inflation caused by straight-forward supply shocks.
To achieve their 2% inflation target, the Fed, the BoE and the ECB may require higher interest rates than had been anticipated and may have to postpone the eventual easing of interest rates.
The ECB was particularly vocal on the point. It talked of ‘significant’ rate hikes to come. In the past it has taken a more dovish tone than other central banks, apparently confident that eurozone inflation was primarily an energy-driven phenomena and, as such, would roll over as – and when- energy prices stabilised or fell.
Now, it is not so sure that an embedded inflation problem can be avoided. Wage growth is creeping up in the eurozone: for example, the German trade union IG Metall recently agreed a 5.4% pay increase for its members in Baden-Wurttemberg, together with a tax-free bonus of Euro 3,000 to help counter inflationary pressures. IG Metall no longer has the same bargaining power that it did thirty years ago, but it remains an influential force in German pay negotiations.
Investors did not like the message coming from central banks, hence the subsequent stock market sell-off.
Investors are paying more attention
The second theme last week was that investors now appear to be listening to the Fed and other central banks’ messaging, a little more carefully.
The caution over inflation, and interest rates, expressed by the Fed last week was not new. For months it has given a nuanced message, warning of the likely persistence of inflation, even as headline and core CPI fell from their late-summer highs. It has made clear its desire to see a weaker jobs market to bring down wage growth, while preventing a recession and seeking a soft landing for the economy.
But the rally on U.S. and global stock markets, from mid-October to the end of November, suggested that investors were accentuating the positive elements of the message (falling inflation, a Fed nervous of damaging the economy) and ignoring the negative. Perhaps believing that central banks were issuing the warnings as an insurance policy, in case more aggressive action was needed over the coming months.
This week we saw a less one-sided reading of the Fed message by investors. The warnings are being taken seriously.
So, what are the new market forecasts for interest rate? For the Fed, around 5% (from the current range of 4.25%-4.5%), the ECB around 3.5% (from the current deposit rate of 2%), and the Bank of England to around 4.5% (from 3.5%).
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