“Time for a holiday”
In this world of 24/7/365 news, it is difficult to switch off. However, many central bankers have managed to escape from their daily grind to have an all expenses paid conference amongst the natural wonders of Wyoming, a good opportunity to put some perspective into their decision making.
The attention of investors is moving towards an important event from 25-27th August, namelythe central banker ‘summer camp’ at Jackson Hole in America. This is an opportunity for many of the great and good to meet and exchange views, as well as listen to some of the latest research and thinking on the topics du jour. Clearly there is much to consider: the future of forward guidance, the potential developments in the Russia-Ukraine war, recalibrating faulty inflation models, the increasingly complicated relationship between central banks and finance ministries.
The title of this year’s gathering is “Reassessing Constraints on the Economy and Policy”.
The main focus of attention will be a key note speech from Fed Chair Jerome Powell. He has a difficult balancing act. Of course he will stress the Fed’s commitment to getting inflation back to target, but at the same time he must express caution about overly aggressive rate hikes which might cause the economic downturn to overshoot. After all, the US economy has pretty much flatlined in the first half of the year.
There has been considerable speculation amongst analysts about what sort of questions he and his colleagues will address. Is monetary policy now neutral? Is there a case for shifting to smaller rate hikes given the uncertain impact of past tightening measures? How long will rates need to be held at their peak to anchor inflation and inflationary expectations at around 2%? At the end of the day, however, the balance of market opinion has shifted towards the view that Jerome Powell will be relatively hawkish in his remarks. The Fed will raise rates as far as is required, and for as long as it takes, to lower inflation.
The task facing central bankers is complicated by growth and inflation trends pointing in different directions. Certainly, the latest business surveys do suggest that economic activity will slow in the major economies in the second half of the year. Manufacturing and service sector reports in the USA, EU and UK have fallen into a range of 44-51, generally back to levels last seen in mid-2020, suggesting at best weak growth and in some cases recessions in various sectors. However, bond markets appear to have paid more attention to further increases in commodity prices, especially energy. For example, natural gas futures in the UKhit a record high, six times higher than last year. This helps explain why a bank such as Citigroup caught the headlines this week with its forecast that UK inflation is on course to hit 18.6% a year in January — the highest peak in almost half a century.
Interest rate expectations have responded. The market place is pricing in hikes in the USA to a 3.50-3.75% target range by spring 2023. Perhaps more importantly, the market expects only a slow decline, with rates still about 3% in mid-2024. The UK is similarly expected to see rates reaching 4.0% or even 4.25% by next spring, only declining slowly to 2.25% by end 2025. Admittedly the outlook for monetary policy in the UK remains rather uncertain. The prime issue is the degree of help provided by the government to all households as they struggle to cope with the energy price surge. Nevertheless, this backdrop helps explain why the yield on 2 year gilts is now trading about 2.8%, compared with 1.8% just a month ago.Europe is not expected to be as aggressive in its tightening, hence the European yield curve is still upward sloping versus the inversion seen in the USA and UK. However, the markets are more firmly pricing in that the ECB will raise interest rates by 0.5% at its September meeting. The latest set of ECB meeting minutes illustrated how the momentum towards more aggressive action changed between the June and the July meeting and also indicated its determination to continue hiking rates on a path towards normalisation.
Central bankers will enjoy their opportunity at Jackson Hole to exchange news and views about the outlook for growth and inflation, politics and geopolitics. Markets may have priced in a rather more aggressive series of statements from policy makers at the conference, but unless growth statistics quickly slide or energy prices collapse, then the recent direction of bond yields and mortgage rates will reassure many central bankers that they are on the correctpath to get on top of an inflation problem.
Bond yields at the time of writing this week
% 2 year 5 year 10 year
USA 3.36 3.17 3.05
UK 2.80 2.58 2.62
Germany 0.86 1.07 1.31
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