Central bankers face a more complicated task
Last year, the job of a central banker was easy: raise interest rates to slow the economy, monitor how monetary policy works through its various channels, such as higher mortgage rates slowing the housing market, and watch inflation fall back towards the official target. Investors have had to consider a complicated series of questions, firstly, when this hiking cycle would begin to take effect, then how deep the slowdown would be, potentially resulting in recession, and lastly how quickly inflationary pressures would respond. In recent weeks, however, both policy makers and investors have seen economic reports showing that inflation is stickier than expected, and the global economy stronger than expected. If activity is more resilient to tighter monetary policy, then central bankers will need to do more.
The UK economy has been holding up a little better than expected, so recession fears are dissipating. Certainly consumer spending was under downward pressure, for understandable reasons related to the squeeze on household incomes. However consumption appears to have been stronger than expected in December and January. Companies are responding; in the UK purchasing manager survey, firms reported their first growth in seven months. Indeed, the rebound in the UK survey was amongst the strongest in the leading economies.
This more upbeat picture was matched in other countries. The US Conference Board’s long-established indicator of economic momentum was flattish in Q4, but suggested that the pace of the US economic expansion improved last month. This was matched by a business survey from S&P which also rebounded, especially in services if less so in manufacturing. Similarly, the Eurozone S&P PMI survey showed activity rose at the fastest pace since May 2022, with domestic and export demand both recovering, whilst separate measures of the business climate in both France and Germany snapped months of contractions.
How did central bankers respond? MPC member Catherine Mann made a major speech talking about the long unknowable lags between policy decisions and their economic effect. She worried that “monetary policy has taken a path which has been historically aggressive, but perhaps insufficiently so relative to the multiple shocks, the behaviours pushing up inflation, and the initial accommodative starting point” and “all this adds up to financial conditions that are now looser than what likely will be needed to moderate the embedding of on-going inflation into the wage and price-setting paths”. Central banker speech for “you have been warned!”.
At the ECB, Isabel Schnabel said “markets are priced for perfection….there is a risk that inflation proves to be more persistent than is currently priced by financial markets” so the central bank may need to “act more forcefully”. Francois Villeroy de Galhau proposed the peak for rates could be as far away as late September; “we need to be wary of declaring victory too soon” so rate cuts are “further off in the future, and definitely not for this year”. Olli Rehn agreed “with inflation so high (core CPI is running at 5.3% a year), further rate hikes beyond March seem likely, logical and appropriate…. I assume that we will reach the terminal rate in the course of the summer….it is important that we reach the restrictive level and then stay at that level for some time”.
As well as Fed speeches, markets digested the latest set of minutes from the Federal Open Market Committee. While most policymakers supported a slower pace of rate hikes, that moves of 0.25% rather than 0.5% at each meeting, interest rates would need to move higher and stay elevated “until inflation is clearly on a path to 2%”. Fed Governor Michelle Bowman warned that “I think there is a long way to go before we reach our 2% inflation objective and I think we’ll have to continue to raise the federal funds rate until we see a lot more progress on that”.
Against this background, there was another understandable tick up in bond yields. The peak of US interest rates is now seen as closer to 5.25% in July. ECB rate hike expectations have repriced over the past month, towards a peak of 3.5-3.75%. German 2 year yields are close to a 14 year high. In the UK, the market is drifting towards 0.25% moves in both March and May.
Of course bond markets pay particular attention to growth & inflation data and interest rate decisions. However, the supply of and demand for government bonds will increasingly become important as central banks rein in their purchases. Looking ahead, public sector borrowing figures for the UK will be updated at the UK Budget on 15 March. Although the Treasury saw an unexpected surplus of £5.4bn last month, helped by larger tax payments, the deficit in the past 12 months was still £129 billion, over 5% of GDP. Further ahead, the tortuous process in the USA towards raising the debt ceiling could trouble markets. All in all, life for a central banker looks rather more complicated in 2023 than it was last year.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.70 4.13 3.91
UK 3.92 3.59 3.61
Germany 2.90 2.55 2.49
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