A game of Jenga
You may be familiar with the game of Jenga – each player has to pull one wooden brick from a large tower of wooden blocks without the whole edifice collapsing. Central bankers face that dilemma, yet they demonstrate that they are ready to keep playing the game.
All eyes were on the Federal Reserve this week – would it move by 0.75% or even 1.0%. On the one hand economic growth looks weak into the third quarter and inflation expectations are starting to ease, on the other hand a tight labour market suggests that wage pressures could still affect future inflation. In the event, its decision met both objectives – taking rates up by 0.75% whilst Chair Jerome Powell made it clear that the Fed is split between tightening by 1% and 1.25% over the remaining two meetings of the year. Markets clearly see the direction of travel. The US 2 year Treasury yield has breached 4% for the first time since 2008, the 30 year mortgage rate has reached a new high above 6.5%. History is being made in other ways; the last time the Fed raised rates by 0.75% three times in a row was back in the mid-1970s and early-1980s episodes.
The Fed also updated its forecasts for growth and inflation, colloquially known as the ‘dot plots’ from the accompanying chart of each governor’s views. It was not a surprise to see a more aggressive approach to monetary policy. Rates are expected to end this year at 4.4% and still be 4.6% at end 2023. Thereafter the outlook is rather uncertain; by the end of 2024, the Fed’s members expect rates to be somewhere between 2.5% and 4.5%!
Against this background, the Federal Reserve is projecting slower economic growth, higher unemployment, and higher inflation versus its forecasts made in June. Unsurprisingly, it still refuses to admit that its actions to reduce demand and ease inflationary pressures will push the economy into recession. Nevertheless, the writing is on the wall. Growth in the year to Q4 2022 is only expected to be up 0.2%, only 1.2% in the year to end 2023. Core inflation next year is still expected to be 3%, above the bank’s target. It takes time to bring inflation down as the central bank only forecasts unemployment to rise from 3.7% to 4.4% next year.
An array of other central banks is also taking took forceful action. The Monetary Policy Committee decided to raise rates for a 7th consecutive meeting, up by 0.5% to 2.25%, the highest level since 2008. This occurred despite the Bank acknowledging that the UK economy was entering a modest recession this summer and autumn. A tight labour market and domestic cost pressures were considered more important. There was an interesting split across the MPC’s membership, with three looking for 0.75% but one for 0.25%.
The MPC and Fed were far from alone in tightening policy. Canada raised rates by 0.75% last week. In Sweden, the Riksbank announced a bigger-than-expected 1% rate hike, its most aggressive move in almost three decades. Norway raised rates by 0.5% and signalled another move in November. The Swiss National Bank raised interest rates by 0.75%, bringing them into positive territory at 0.5% for the first time since 2015. Although the Bank of Japan decided to keep its ultra-low rates, it gave a signal by intervening in the foreign exchange market for the first time in 24 years.
Although the ECB did not act this week, several ECB speakers made it clear that more action would happen. ECB President Christine Lagarde said the central bank may need to raise rates to a level that restricts economic growth in order to combat unacceptably high inflation. Chief economist Philip Lane acknowledged that “We do think this is going to dampen demand. We’re not going to pretend this is pain free”. Official rates at 0.75% are still too low as they continue to stimulate the economy. Similarly the ECB’s Madis Muller said slowing inflation “takes quite a long time” and borrowing costs are still near historical lows.
Against this background, it is no surprise that interest rates and bond yields continue rising, as yet another rate increase is priced into the UK and many other markets, whilst the inversion of yield curves becomes more noticeable, or in the case of part of Germany’s yield curve more apparent.
Central bankers face a further dilemma as they play the game of Jenga – how will fiscal policy interact with monetary. Friday will see the all-important ‘fiscal event’ speech by the new Chancellor. There is considerable uncertainty about how energy subsidies will be financed, the amount of tax cutting, the details of the various changes, and the impact on future growth and issuance of national debt. Financial markets see UK interest rates ending this year at 3.5% and peaking at around 4.5% next summer. If the markets are right, we are heading for the sharpest, fastest tightening of monetary policy in more than 30 years. The MPC will need to analyse the Treasury’s announcement carefully, and then decide whether fewer or more blocks should be taken away from the Jenga tower in coming months.
Bond yields at the time of writing this week
% 2 year 5 year 10 year
USA 4.13 3.90 3.66
UK 3.52 3.56 3.50
Germany 1.82 1.92 1.94
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