Be wary of Scylla and Charybdis
Central bankers are caught between a rock and a hard place, between the devil and the deep blue sea, or if we turn to Greek mythology then Scylla and Charybdis. These monsters inhabit the Straits of Messina, the narrow sea between Sicily and the Italian mainland. Odysseus famously had to negotiate a passage through their deadly clutches in Homer’s famous tale.
The first problem – economic growth looks set to slow into 2023, potentially quite sharply. For example, the OECD recently analysed how the world economy is reeling from the largest energy shock since the 1970s. It forecasts that growth in almost every large economy will be weaker next year than it had thought in June. The US and EU will barely expand, while the UK and Germany face a modest recession. This chimes with the latest round of downbeat business surveys in Europe, the USA and the UK . Perhaps more alarming was the news that China’s attempts to open up its economy had to be quickly curtailed, in the face of a sharp spike in Covid cases across many regions. In theory, time for central banks to consider rate cuts – indeed there is speculation that the Chinese central bank might soon do so – and for governments to ease fiscal policy.
The second problem – inflationary pressures are still very evident, and could worsen if President Putin takes more action on energy exports or if the approaching winter is particularly harsh. As it is the Office for Budget Responsibility in the UK forecasts headline inflation to average 7% across 2023, on the key assumption that gas prices halve over the next few years. Workers are striking for higher wages. No surprise, then, that many central bankers wish to tighten monetary policy.
How high should interest rates go? The OECD suggests that the ECB needs to boost official interest rates to over 4% from current levels of 1.5%, with the UK eventually reaching about 4.5%, whilst the Fed should raise its key rate to 5.25%. Such a view is not materially different to what is priced into the markets.
Of course monetary policy need not tighten as much if fiscal policy took some of the strain. However, governments are keen on easing the pain for households, most notably through the stream of energy support packages seen across Europe. The Chancellor’s Autumn Statement actually showed a small amount of fiscal easing in 2023. The bulk of the tightening, to ensure that the ratio of public sector debt to GDP finally rolls over, has been delayed until after the next election.
Hence one of the issues facing the gilts market is an avalanche of future debt. Taking into account planned gilts issuance from the Debt Management Office, and the Bank of England’s quantitative tightening programme, some economists estimate that private investors have to increase their gilt exposure by around £270 billion in 2023-24. That might need higher bond yields to attract sufficient inflows. The interaction between monetary and fiscal policy also needs careful analysis in terms of servicing the large amount of government debt. The OBR estimates that a 1 percentage point rise in interest rates across all maturities forces the government to increase debt interest payments by £25 billion a year.
How are central bankers interpreting these divergent trends? Minutes from the Federal Reserve’s most recent meeting reported that “A substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate” but also “various participants noted that their assessment of the ultimate level of the federal funds rate that would be necessary to achieve the Committee’s goals was somewhat higher than they had previously expected”. In other words, a slower path but the same target. The same view was expressed by some ECB Governors, such as Mario Centeno who said the ECB should slow the pace of interest rate hikes from December; 0.75% moves are not the norm as inflation is likely to peak this quarter. Nevertheless, at a conference in Frankfurt, ECB President Christine Lagarde, Bundesbank President Joachim Nagel, and Dutch central bank Governor Klaas Knot, all made the case for raising rates into “restrictive” territory.
A similar debate is taking place in the UK, of course. There was a statement of the obvious from Sir Dave Ramsden. The Bank may have to cut interest rates if the UK economy slumps into a long, tough recession; if households and businesses are under greater financial pressure than expected, “then I would consider the case for reducing Bank Rate, as appropriate”. However, Chief Economist Huw Pill emphasised the base case – more rate hikes will likely be needed to return inflation to the 2% level. “Given the need to contain the risk of greater inflation persistence implied by potential second round effects, further action is likely to be required to ensure inflation will return sustainably to its 2% target over the medium term”. Lastly, he repeated the Bank’s recent line that he does not envisage raising rates to the levels priced in by financial markets ahead of the most recent MPC meeting which had rates peaking at 5.25%.
Over the past week, US benchmark bond yields have moved down just a little, the UK a little more and European yields rather more. On balance, investors are pricing in that the growth effect will weigh a little more than the inflation factor, and the peak will be a little sooner and a little lower than earlier expected. Of course, that is unless some more monsters unexpectedly appear on the starboard or port of our boat!
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.48 3.90 3.71
UK 3.18 3.21 3.03
Germany 2.08 1.88 1.84
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