Fitting the jigsaw pieces into place
For some weeks, financial markets have been pricing in just one more rate rise by the US Federal Reserve, only a few more for the ECB, perhaps no more by the Bank of England, and then rate cuts before year end. Such an outcome requires a number of pieces of the jigsaw to fall into place.
First of all, labour market reports need to show a definite slowdown in demand and preferably a moderate uptrend in unemployment bringing wage demands under control. So far, the news has been mixed. Last week’s non-farm payrolls report for the US showed job gains in the first quarter averaged 345,000 a month, up from 284,000 in the final quarter of last year. Demand has slowed across the manufacturing sector, but service industries are hiring apace. An unemployment rate of only 3.5% allows plenty of job movement, so wages have grown well over 4% from a year earlier – higher than the Fed would like to see unless productivity really improves.
Such trends are rippling through into core inflation. Certainly, the latest US report showed headline inflation eased to 5%, a two year low. However, the rate excluding food and energy was still running at 5.6%, rather higher than the authorities would like to see, led by housing and auto related inflation.
Central bankers are hinting that they will pause after months of policy tightening. Yet the latest minutes of Fed discussions showed that the slow pace of disinflation worried many members, against the backdrop of only a “mild recession” starting later this year with a recovery in 2024. Banking sector turmoil was important: “Some participants noted they would have considered a 0.5% increase in the absence of the recent developments in the banking sector”.
As ever, subsequent comments showed the range of views across the committee. Harker said he feels the Fed may soon be done raising rates. “Since the full impact of monetary policy actions can take as much as 18 months to work its way through the economy, we will continue to look closely at available data to determine what, if any, additional actions we may need to take. I’m in the camp of getting up above 5% and then sitting there for a while”. Mary Daly said that while there are reasons to think more tightening is needed to tame inflation, “there are also good reasons to think that the economy may continue to slow, even without additional policy adjustments.” Kashkari warned that the interest rate hikes and possible pull back in lending after two bank failures could trigger a recession, but allowing inflation to stay high would be even worse. “It could be that our monetary policy actions and the tightening of credit conditions because of this stress leads to an economic downturn. That might even lead to a recession”. But “we need to get inflation down. If we were to fail to do that, then your job prospects would be really hard”.
Even if the Fed soon pauses, the balance of discussion in the ECB is looking for more action, rippling through into European bond markets. Robert Holzmann felt that “the persistence of inflation currently argues for another 0.5%. We must continue to act decisively and raise key interest rates noticeably even beyond May”. Pablo Hernandez de Cos worried that “core inflation is expected to remain elevated in the rest of the year. That may delay convergence towards the 2% target in the medium run and that will therefore need close monitoring”. If the ECB’s baseline scenario were to be confirmed, “we still have ground to cover to make sure that inflation pressures are stamped out”. Edward Scicluna and Martins Kazaks were of similar views, arguing for an increase of 0.25% or 0.5% when they meet on 4 May. Indeed Kazaks said he does not see any reason to slow down any time soon in terms of interest-rate increases.
The Bank of England is seen as closest to halting rate increases, which is understandable against the backdrop of an economy hardly growing for several quarters. The Office for Budget Responsibility estimates that real household disposable incomes will fall by 2.6% this year on top of a decline of 2.5% in 2022. However, Huw Pill, the Bank’s chief economist, returned again to the importance of the labour market in the committee’s thinking. Although he sees a “clear sign of some turning in wage momentum”, he expressed concern that the moderation had now hit a wall, leaving wage growth at a rate that was incompatible with bringing inflation back down to the Bank’s 2% target. He admitted that there was disagreement within the MPC about whether the economy requires higher unemployment for inflation to return to target.
Looking further ahead, central bankers are well aware that the backdrop is muted global economic growth for some time to come, unless there is a major decline in energy costs or the Chinese government takes serious action to boost its economy. As part of the spring meetings of the World Bank and IMF, the Fund forecast that global growth would be only 2.8% this year before edging up to 3% next. It concluded that the reasons why interest rates have been so low for so long have not gone away; an ageing population, the impact of new technologies, a high debt burden and high income inequality remain common factors across advanced economies. Lastly, the Fund worried that the global economy was entering a ‘perilous phase’, partly due to recent banking turmoil. Bank lending capacity is expected to decline modestly this year. Some signs are already appearing; the USA’s small business sentiment index edged lower last month partly on concerns over credit availability.
To sum up, a number of the pieces of the jigsaw are falling into place for central banks to do a little more policy tightening before pausing to assess the situation. Whether the picture allows rate cuts by year end remains to be seen.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 3.97 3.49 3.44
UK 3.48 3.38 3.56
Germany 2.78 2.39 2.38
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