Three of the world’s major central banks raised their interest rates this week: 25bps from the Fed and 50bps from the ECB and the Bank of England. And what was the reaction of financial markets to tighter monetary conditions? To party.
Bond and stock markets have rallied strongly in response to this week’s central bank rate hikes, which is not the usual response to tighter monetary conditions. The rallies follow strong gains over January across most asset classes.
Why the disconnect? Principally because investors suspect that the central banks are nearing the end of their tightening cycles. Investors are looking ahead to days of low and stable inflation, interest rate cuts, and a rebound in economic growth, with only the U.K. now likely to suffer a recession this year (among the major economies).
They are, perhaps, pricing in perfection. They appear to be missing the nuances of the inflation story, in particular, the real risk of wage growth causing an embedded core inflation problem. And they are -once again- hearing what they want to hear from admittedly confusing messages from the central banks.
Nuances and garbled messaging
Reduced energy prices, lower container costs, and below-inflation wage growth across the developed world have all helped to bring down inflation over the last six months. Further sharp falls expected in year-on-year headline CPI inflation numbers over the spring and early summer.
But few economists believe that headline CPI can be brought down to the 2% target rate and remain there as long as we see tight labour markets contributing to wage growth. As inflation falls below nominal wage growth, wage growth may become positive by the end of the second quarter in many countries. Could this stimulate demand ahead of available supply in the economy, and so trigger more inflation?
Jerome Powell of the Fed made it clear on Wednesday that a wages-prices spiral is not yet in place in the U.S. economy (as we saw in the 1970s), but he fears one embedding itself. So how tough should central banks be on this issue? Do they risk a recession by overdoing rate hikes to destroy wage growth?
Garbled messaging from the Fed’s Jerome Powell and the ECB’s Christine Lagarde meant their views on the inflation risks of the coming months were lost.
Sure, both mentioned the difficulties of reducing inflation and the importance of keeping inflation expectations anchored. They used near identical language at times regarding curbing inflation: that ‘the job is not fully done’ (Powell), and ‘we know we are not done’ (Lagarde).
But both then seemed to qualify their determination to fight inflation. With Powell, it was from the very first question. This was ‘are you concerned about the recent loosening of financial conditions?’ (i.e., ‘has the January rally in bonds and stocks caused a problem, when you are trying to reign in consumer and business confidence and spending?)
Powell wavered. Which was odd, given that this has been a frequent point of discussion over the last year. In doing so, he gave the impression that he is not as hawkish as he would like them to believe.
If the Fed wanted to leave investors wary of inflation and of upside risks to current market interest rate expectations, Powell failed to do so. The ECB was more obviously hawkish, but Lagarde stumbled over questions that made it appear it was a somewhat conditional-on-the-data hawkishness.
The Bank of England was more explicit, dropping its previous guidance that rates are likely to rise again.
The risk of ‘higher for longer’ interest rates seems real
This week’s central bank announcements left markets confident that the peak of the current interest rate cycle is fast approaching.
In the U.S, another Fed 25bps rate hike to go is the prediction of JP Morgan Asset Management’s fixed income team (which would take Fed funds target rate to 4.75%-5%), while the financial markets predict perhaps two more 25bps hikes from the ECB (taking its key rate to 3%), and one more 25bps rate hike from the Bank of England to take its key rate to 4.25%.
But the lurking problem of wage growth and core inflation won’t go away. If we also consider the inflation potential of China re-opening and the potential for more energy disruption from one of the geopolitical themes currently happening, the risk of ‘higher for longer’ interest rates than are currently expected seems real.
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