MUNIX WEEKLY 14th April
‘It’s tough to make predictions, especially about the future’
Economists and investors have loved the blizzard of official statistics, central bank speeches and policy decisions which greeted them this week. This enabled them to update their forecasts and compare with the official views. The net result is that the terminal rate for Bank of England base rate in 2023 is expected to reach 2.5%, mid-way between the terminal rate of 1.25% for the ECB and 2.75-3% for the Federal Reserve.
Inflation and labour market data put further pressure on the Bank of England to act. Headline inflation reached 7% year on year on the consumer prices index, whilst the retail prices index jumped to 9% in March, its highest in 31 years. Hawks on the MPC will not look with favour at the signs that wage pressures are building as demand picks up and skill shortages come to the fore, resulting in average earnings growing above 5% from a year ago. The Bank of England has warned that CPI inflation could head above 8% in coming months. Banks such as Nomura, Deutsche Bank, JP Morgan and Bank of America all see figures closer to 9%.
US consumer price inflation was a little worse than expected, rising by 8.5% from a year ago. Even stripping out the volatile food and energy components, core inflation was still running at 6.5%. Although analysts expect inflation to peak in March or the next few months – gasoline and car prices are rolling over – it is likely to remain substantially higher than the central bank’s target of 2% well into next year. For example, Deutsche Bank expect US inflation to end this year at 5.0%, and still be above 3% a year at end 2023.
Fed Governors continue to try and inform the markets. Richmond Fed President Barkin is worried that upward pressures could stick around if firms remake supply chains more resistant to potential disruption, if governments spend too much on benefits for an aging population or on defence, or if slowing population growth means labour constraints. “Our efforts to stabilise inflation could require periods where we tighten monetary policy more than has been our recent pattern”. Bullard was blunter, when he warned that it is fantasy to think that modest rate increases will tame inflation.
On balance, markets paid more attention to tomorrow’s forecasts, rightly or wrongly. Investors continue to price in back-to-back 0.5% hikes into the summer and around 2% of total tightening by year-end. However, on balance investors were a little more reassured about the future inflation path and scaled back their expectations for the terminal Fed funds rate from 3% closer to the 2.75% area.
The ECB is not in an easy position. How will the war develop? Will Russia shut down gas exports to Europe? Will EU governments implement tax and subsidy packages to offset the impact of the energy crisis? Executive Board Member Isabel Schnabel explicitly called for targeted fiscal support to those hardest hit by the crisis, avoiding a general fiscal and monetary policy expansion that would fuel further inflationary pressures.
Unsurprisingly, the central bank kept its options open at its Match meeting. The risk assessments did shift: the downside risks on growth have “increased substantially”, while “the upside risks surrounding the inflation outlook have also intensified, especially in the near term”. There were few hints about interest rate decisions whilst there was a somewhat stronger commitment to ending net asset purchases over the summer.
Accordingly, analysts trimmed their bets on the chances of a July rate rise but still expect to see one in September, and a second around year end. This would take the ECB’s deposit rate back above zero by the end of the year and to 1.25-1.5% by the end of next year.
It is important to emphasise that forecasting is a difficult business. To put all the figures in this note into context, we should simply look back at the lack of success which central banks have had in forecasting recent inflation. It is not singling out the Bank of England to note that last May it forecast no coming spike in inflation at all, last August it expected the peak this year to be 4% this year, by November, the projected peak had only risen to 5% – and by February this year the Bank saw the coming peak as 7%. Even if and when there is a peak in inflation, as energy or food prices fall back, inflation looks likely to be sticky. In the short term, forecasts are highly uncertain depending on how the Ukraine war and China slowdown affect energy prices. Further ahead, such issues as deglobalization and re-shoring, supply chain disruptions, the climate change transition, the relationship between fiscal policy andhistorically high debt levels, or monopolistic corporate behaviour, none of these look likely tobe solved quickly. Accurate forecasting is not an easy thing to do!
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Bond yields at the time of writing this week and one month change
% 2 year 5 year 10 year
USA 2.45 (+0.58) 2.77 (+0.68) 2.81(+0.67)
UK 1.56 (+0.13) 1.63 (+0.26) 1.90 (+0.30)
Germany 0.04 (+0.40) 0.58 (+0.50) 0.84 (+0.48)
Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making