Three central banks with plenty in common

Despite the rise in market volatility and worries over financial stability over the last couple of weeks, central banks have ploughed on with rate increases.

The European Central Bank (ECB) hiked 50bps, the Federal Reserve (Fed) hiked 25bps and Bank of England (BoE) hiked 25bps. In hindsight, all these rate hikes could prove late cycle policy errors, but for now look justified against a backdrop of too-strong domestically driven inflation.

Another thing these central banks have in common after this last set of meetings, is a lack of firm forward signalling, even about the very near-term outlook for policy. All three indicate an uncertain path for the economy with a data-dependent approach to monetary policy decisions in the months ahead.  

Assuming that financial volatility subsides, I still think central banks have a bit more work to do. We could again find we are in a ‘good news is bad news’ environment where positive activity data is greeted by fears that central banks will need to hike more than expected. But the outlook is hard to pin down against a backdrop where financial market volatility can feed through strongly to the real economy, but where hard-to-predict confidence and sentiment will play such a crucial role in what happens next.

Financial market volatility and the real economy: I am expecting recent financial market volatility to have had some impact on business confidence and have increased perceived economic uncertainty. That itself should dent economic activity for a period and leaves me a bit more comfortable than I was with my forecasts for modest recessions to emerge in the US, UK and euro area before the end of 2023. Bank behaviour will be critical, in particular how far do banks tighten up on lending and do they increase rates offered to depositors (helping secure those depositors but – at a macro level – disincentivising consumer spending). Even before March 2023, bank lending conditions looked to have tightened significantly in the US, euro area and UK.

Still expecting inflation to fall a lot either way: I am expecting year-on-year inflation to fall substantially in major economies over 2023, led by externally driven inflation. Powerful negative base effects, especially in the energy component, are likely to pull year-on-year headline inflation lower (base effects mean that even if energy price levels stay where they are, year-on-year inflation in various energy prices would rapidly decline over 2023). Commodity prices remain below their mid-2022 highs; that should, for example, also feed through into falls in food prices (with a lag).  Core goods Consumer Price Index inflation is likely to fall further, led by lower commodity prices and eased supply chain pressures.

There are plenty of risks to inflation forecasts though, especially in terms of how fast and how far inflation falls. For now, I am still more worried by upside than downside risks.

• Measures of core inflation still look uncomfortably strong in many economies and labour markets tight enough that it is hard to feel confident that pay growth is going to sustainably return to levels that central banks at least will be comfortable with.  
• On the downside, recent financial volatility could feed through into sharply tighter bank lending conditions and overall credit conditions, slowing economies — and domestically driven inflation pressure — much more than expected.

Central case: Another rate hike and no rate cuts in 2023; but things could change quickly: My central forecasts assume that the Fed, ECB and BoE all have around one more rate hike to go before reaching peak rates for this cycle. Recent financial market volatility clouds the outlook, but underlying inflation pressure still appears strong and as Fed Chair Powell has put it “Without price stability, the economy does not work for anyone.”

For the Fed, one more 25bps rate hike would be consistent with Federal Open Market Committee participant forecasts (the median interest rate forecast published alongside the March decision). Although there were ‘dovish’ changes made to their guidance language, I would describe their tone as cautious, reflecting economic uncertainty, rather than dovish. They seem to have assumed that there will be a further tightening in credit conditions. If there isn’t, more than one rate hike seems likely. As Chair Powell put it, the process of getting inflation back to 2% has a long way to go.

The BoE (not unusually) have not signalled a near-term policy path, but data indicating inflation persistence remains a clear focus for their decision-making. Domestically driven inflation still looks strong to me.

The ECB sent a strong ‘data dependent’ message on the future policy path at their March meeting.  They are watching developments in financial markets closely. However, they have also been clear that if financial volatility doesn’t knock their base case economic forecasts off course, then they still have ‘work to do’. Given ECB communication, I would see clear upside risk to my ECB interest rate forecast if that proves to be the case.

How far each central bank needs to hike rates is a different question to how far they will hike rates, but all three likely want to feel confident that inflation is sustainably going to hit their target and headline inflation being off its highs hasn’t been enough for them to end their rate hiking cycles. Central banks are particularly sensitive to domestically driven inflation. They have very limited control over externally driven inflation (e.g. that driven by energy price shocks). Domestically driven inflation is the kind of inflation they feel they can impact; it is the kind of inflation driven by things like domestic inflation expectations and wages and it can prove sticky. In the US and in many other major economies, measures of inflation that proxy domestically driven inflation still look too strong.

In contrast to current market pricing, my forecast is that rate cuts are a 2024 (after modest recessions) rather than 2023 story. However:

1. Recent financial market volatility increases the risk of tighter credit conditions. Without needing a direct trade-off between financial and price stability, central banks could end up cutting rates if there is a strong downside impact from financial market volatility on the real economy and the inflation outlook. 
2. If the recent financial volatility blows over, it is still plausible that central banks hike significantly more than expected in coming months if labour markets remain tight and inflation fails to cool enough. ‘Good news’ on the economy could be ‘bad news’ in that sense. Those extra rate hikes could push economies into more significant downturns and ultimately also see interest rates having to be cut earlier than in the central case.

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