It’s not easy to listen when there is so much noise
Central bankers have faced a cacophony of noisy signals and news in recent days: inflation is not declining as fast as they would like, and economic data suggests continued growth, yet more banks are in trouble, even requiring the rescue of one of the world’s globally systemically important institutions. Bond, currency and stock markets are showing considerable day to day volatility, giving no firm steer about future economic or financial sector prospects. Indeed, one measure of bond market volatility reached its highest since the last major financial crisis broke out in 2008. What to do?
The Federal Reserve decided to move interest rates higher by another 0.25%, despite continued stress in the banking sector such as talks about another rescue package for First Republic. As Chair Jerome Powell explained “We have to bring inflation down. There are real costs of bringing it down to 2% but the costs of failing are much higher.” Investors seized upon the moderate tone and tenor of his remarks about future moves, so only “some additional policy firming may be appropriate”. The Fed’s decision was understandable in the light of its latest forecasts. Most officials still expect the policy rate to peak at 5% or 5.25% this year, and maintained at that level for much of 2024, only falling back to 4.25% at the end of next year. As Powell said “rate cuts are not in our base case.” In contrast, financial markets are anticipating rate cuts of about 0.5% by year end.
Such a ‘steady as she goes’ view at the Fed is based on a modest recovery in economic activity, with GDP growing by 0.4% in 2023, then 1.2% in 2024 and 1.9% in 2025. The lack of a recession means unemployment stays low, and inflation is sticky. Core inflation is forecast to be 3.6% at end 2023, still above target at 2.6% for end 2024. Admittedly, there is considerable debate within the Fed which underpins such a consensus view; the estimates for the official Fed Funds rate in 2024 range from 3.5% to 5.5%. The future is very uncertain!
The Bank of England agreed that action was needed, with the 11th successive rate increase reaching 4.25%, clearly prompted by the latest adverse inflation report. Headline CPI rose to 10.2% a year, contrary to expectations that it would fall back below 10%, whilst core inflation was steady at 6.2%. Food prices were significant (up 18% a year!) but there are signs that high wage inflation is feeding through into the service sector. Markets are debating whether the MCP has reached the peak, or needs to hike again in May. Even so investors find it hard to price in a rate cut before year end.
More detail also appeared on why the ECB raised interest rates last week, despite ongoing problems with European banks. The central bank had cut its inflation forecasts modestly, but said price pressures were still “projected to remain too high for too long”. In subsequent remarks, Bundesbank chief Joachim Nagel said eurozone policymakers must be “stubborn” and continue increasing borrowing costs to battle inflation. “Our fight against inflation is not over….price pressures are strong and broad based across the economy”. “There’s still some way to go but we are approaching restrictive territory”. He also said that once the ECB stops raising rates, it will resist calls to cut them. He was supported by the governors from Estonia, Lithuania and Slovakia who all suggested more tightening is needed.
The OECD continues to call on central banks to raise rates in a bid to lower inflation in the medium term. In its updated economic outlook, the organisation forecast global growth of about 2.5-3.0% in 2023-24, amidst improved business and consumer confidence, lower food and energy prices, and the re-opening of China’s economy. But it warned monetary policy “needs to stay the course”, at least until there are clear signs that “underlying inflationary pressures are lowered durably”. The reason is that it forecasts only a gradual decline in headline inflation – from 8.1% in 2022 to 5.9% in 2023 and 4.5% in 2024. It concluded central banks will have to maintain high policy rates “well into 2024”.
Looking into the summer, central banks will monitor both economic and banking news. A clear risk is a major or sudden fall in money supply as banks pull back on their lending. As Jerome Powell said, banking industry stress could trigger a credit crunch with “significant” implications for the economy. “We’ll be looking to see how serious is this and does it look like it’s going to be sustained… it could have a significant macroeconomic effect, and we would factor that into our policies”. All central banks carry out regular surveys of credit availability. Last quarter, about 40% of US loan officers said that they had tightened lending standards in the commercial real estate space. A New York Fed survey showed the denial rate for auto loans rose to a six-year high in February. Such trends are being monitored elsewhere; European money supply growth has been weaker for some months.
Even if this banking crisis dies down, and there are reports that PacWes bank is facing deposit outflows, investors face other issues. One concerns the speed with which bank deposits can move, another relates to the bonds which form part of a bank’s balance sheet. The MPC’s Andrew Bailey criticised the US government’s decision to bail out all Silicon Valley Bank depositors, that is those above and below the official $250,000 deposit guarantee, saying such a blanket decision increased the risk of “moral hazard” in the banking industry. The US Treasury has given mixed reports about whether they are planning to provide blanket deposit insurance to all US banks. Secondly, the rescue of Credit Suisse by UBS involved writing off $17 billion of the bank’s debt, which investors had not expected, potentially upsetting a $250 billion market. Regulators and investors have quickly realised that high capital ratios are no defence against a rapid loss of confidence and flight of deposits, made ever easier with digital banking. As Karen Ward from JP Morgan asset management concluded “banking turmoil will lead to further tightening of lending standards”.
Amidst the cacophony of noise this week, financial markets focused on the moderate remarks from Jerome Powell about future rate hikes, and continue to expect central banks to stop raising rates soon and make cuts by year end. Against the backdrop of continued stress across the banking sector that is understandable, but if the financial sector starts to look safer then expect more central bankers to begin to shout once again that they wish to see rates higher for longer to ensure inflation is well and truly brought back under control.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 3.82 3.43 3.41
UK 3.28 3.20 3.36
Germany 2.45 2.16 2.17
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