Which target should I shoot at?
Central bankers face a major problem: which target should they shoot at? If they focus on the real economy, then monetary policy should remain tight in coming months, more so at the ECB than the Federal Reserve, and least of all for the Bank of England. If they focus on equity markets in general, and the banking sector in particular, then interest rates need to be cut. Some of the technical measures of stress in bond, currency and stock markets are back at levels last seen at the start of the pandemic in spring 2020.
Fears of another global banking crisis are escalating. When interest rates rise aggressively, it is common for weak spots in the economy or markets to appear. The famous Warren Buffet quote is “only when the tide goes out do you learn who has been swimming naked.” The latest crisis began in the USA, with the unexpected closure of SVB and Sovereign, whilst First Republic required a $30 billion liquidity injection. A massive run on bank deposits caused Moody to downgrade the credit rating of the US banking system from stable to negative. Concern then switched to Credit Suisse, one of 30 globally systemically important banks; already in a weak position, it was forced to seek $50 billion of central bank support. Share prices of many American, Asian and European banks have fallen markedly. Expectations for lower profits reflect a mixture of a flight to safety from bank deposits to money market funds and government bonds, plus rapid changes in the shape of the yield curve, and signs that demand for loans will be lower. It would not be a surprise to learn that active traders and hedge funds have also been forced to liquidate overly extended positions in short order.
Markets were pulled another way though by the latest strong US data. Employment growth in February was sufficiently strong that average earnings are still growing 4.6% a year. Retail sales are erratic, but the underlying rate of growth supports estimates that the US economy could be growing 3% a year. Although headline inflation is decelerating, core inflation at 5.6% year on year is still much higher than the Fed would like to see.
Over the past week banking stress has overcome economic stress, although day to day volatility has been remarkably high. For example the US 2 year Treasury yield demonstrated the largest one-day slump since 1982. The net result was much lower interest rate expectations; in effect the pivot towards lower interest rates in December and January on recession fears, which had been priced out in February due to continued strong inflation data, has now been priced back in. On balance the markets have decided that the Fed’s next move is more likely to be zero or 0.25% rather than 0.5%, that the peak will be closer to 5.0% than 5.5%, and that significant rate cuts could appear by year-end.
The ECB faced a similarly difficult decision about whether to focus on the upbeat economy or sharp declines in European bank shares. It matched expectations by raising interest rates another 0.5%. Christine Lagarde emphasised that action was needed; after all although headline and core inflation are expected to come down significantly over the next years, on the ECB’s forecasts it would still be modestly above target as far out as 2025. However the bank provided some cautious signals, including a lack of forward guidance on rates, alongside little likelihood of reducing its balance sheet by requiring banks to repay some of the massive liquidity provided to them in recent years. European bond markets rallied sharply in response to fading expectations of further increases in borrowing costs. Hence, the 2 year German bund yield saw the biggest one-day drop since Bloomberg’s data started in 1990.
UK bond markets benefitted not only from these international signals but also the weak economic outlook despite the Chancellor’s decisions in the Budget. Forecasts from the Office for Budget Responsibility helped support the Bank of England’s recently more cautious stance. The UK economy will hardly grow during 2023, whilst inflation is expected to drop sharply to reach 2.9% at year-end (in February the MPC’s forecast was 4%). The OBR has revised down yet again its assumptions for medium-term growth, only about 2% a year out to 2026. Real living standards are set to fall by 6% over last year and this year, ‘the largest two-year fall since records began in 1956-57.’
Neither was there much fiscal stimulus or contraction to affect the MPC’s analysis. Treasury figures showed how the government has little room for manoeuvre in terms of borrowing or taxation. Higher corporate taxes and £30 billion a year of fiscal drag on household incomes (the thresholds for income tax have been frozen since 2021) mean the tax burden reaches 37% of GDP, a post war record. The OBR estimates that the Chancellor’s headroom against the government’s main fiscal goal – to see debt fall as a % of GDP across the medium-term – is a negligible £6.5bn at the end of its forecast period.
Hence, the government had to turn to supply side reforms to try and improve long standing problems facing employment and investment growth in the UK – albeit these will take years to have an effect. Lower energy prices and hence inflation forecasts reduced public sector borrowing projections for this year by roughly £30bn, and the Chancellor spent roughly three-quarters of that on targeted interventions to boost labour supply (there are about eight million inactive working-age people) and investment (which has been essentially flat since 2016). However, the OBR estimated that such supply side reforms would only boost GDP by about 0.25% by 2027.
An IFS summary is useful: “The bigger fiscal picture hasn’t changed enormously since the autumn. The OBR expects the economy to grow a bit faster in the short-term, and a bit slower in the medium-term, combining to produce an economy 0.6% larger in real-terms in 2027–28 than under the autumn forecast. The government remains on track to meet its relatively loose fiscal targets by only the barest of margins, despite a historically high tax burden and some extremely tight post-election numbers for spending on public services. Debt interest spending is forecast to remain well above what was forecast a year ago. And we are still in the midst of an enormously difficult period for households. We’re by no means out of the woods yet.”
The MPC will also be reassured by the UK’s latest employment report. There was a decline in vacancies whilst average earnings growth slowed, to either 5.7% or 6.5% a year depending on bonus calculations. On balance, the financial markets currently see no change or a hike of 0.25% at the next meeting, depending on the state of the banking system.
A week is a long time in politics, but also a helpful period of time for central bank governors. The Fed next meets on 22 March, by which time the dust around this banking crisis may have settled. Investors are convinced that bank profitability will be hurt; they still await evidence of whether this tips into further bank failures and an even greater economic impact. Other problems potentially lie ahead, such as the fraught debate over raising the US debt ceiling. Central banks remain caught between keeping interest rates high to address overly strong economies, or lending much more support to the banking system in order to prevent financial instability.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.17 3.74 3.57
UK 3.43 3.36 3.43
Germany 2.61 2.31 2.27
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