What will central banks do next? It all depends….
As expected, both the Federal Reserve and the ECB decided to raise interest rates by 0.25% this week. In both cases the central banks indicated that they are now ‘data dependent’, indeed ‘event dependent’ or even ‘weather dependent’, to determine their next moves, whether we see small increases, or no change, or even actual rate cuts by year end. As John Maynard Keynes is supposed to have said “When my information changes, I alter my conclusions. What do you do, sir?” Financial markets know best, of course, and see the Fed, the ECB and MPC forced to change direction before year end.
The latest move by the Federal Reserve may be the peak. Its statement indicated that it is moving to a meeting-by-meeting approach to policy setting, as it has possibly done enough. Jerome Powell said, “if you add up all the tightening that’s going on through various channels, we feel like we’re getting close or maybe even there.” The Fed’s central forecast remains for modest economic growth, so more evidence of an actual recession would be needed to warrant a change of direction.
The ECB similarly raised rates by 0.25%. In contrast to the Fed, however, Christine Lagarde tried to send a rather hawkish message at her press conference. She kept the door open for further action “we have more ground to cover and we are not pausing” as “the inflation outlook continues to be too high for too long”. An additional nuance relates to some technical aspects of how the ECB will carry out quantitative easing this year, in effect leading to an additional moderate tightening of monetary policy into the summer.
Central banks are data dependent, but the data remains rather mixed in the USA, Europe and the UK.
Admittedly, the US manufacturing sector PMI survey eased to 47 in April, the 6th successive month below the boom-bust 50 level. New job openings are near a two-year low as firms layoff more staff. However, hawks would point towards employment costs for US companies still growing robustly at 4.8% year on year, whilst analysis by the Dallas Federal Reserve bank showed that more than 40% of the components of their preferred consumer expenditure inflation measure are rising at more than 5% a year.
Economic output across the Eurozone only grew 0.1% in Q1 as domestic consumption was very restrained. However, growth looks positive for Q2. Whilst the manufacturing sector PMI survey eased again to only 46 in April, a three-year low, the corresponding and more important services sector result at 57 showed a strong expansion. This may explain why unemployment has eased to a new low of only 6.5%. Doves on the ECB will point towards weak money supply across the Eurozone though. A recent survey indicated the biggest pull back on credit growth since the eurozone debt crisis as banks stop lending to riskier borrowers.
The situation is not markedly different in the UK. Consumers are still spending, as shown by a CBI retail sales report for April, on the back of credit growth. The Purchasing Managers Index also showed an expansion, up to 55 in April, as services strength again offset manufacturing weakness. There is good news for the MPC that headline inflation should finally fall below 10% a year; the British Retail Consortium reported weaker non-food price rises last month.
It is important not only to look at macro-economic data. There are signs that banks in many countries continue to tighten lending standards. This is partly to raise capital ratios to reduce the risk of runs, partly in anticipation of tighter bank regulation, and partly a response to deteriorating conditions around commercial real estate.
Hence, policy makers are ‘event dependent’. Various US regional banks are facing considerable pressure, notably Pacific West’s share price has fallen by 60% from their peak as investors forecast a rescue, whilst Western Alliance is “exploring strategic options”. Looking ahead, Jerome Powell at the Fed has acknowledged that “strains that emerged in the banking sector” in the wake of Silicon Valley Bank’s collapse in March have led to “even tighter credit conditions for households and businesses” on top of the impact of multiple interest rate increases.
Another event which could change the mind of central bankers would be a shutdown of the US government. The Senate showed no signs of moving to avoid a debt ceiling crisis as Republicans rejected calls to raise the $31 trillion limit without conditions, and Democrats dismissed the idea of further talks. On some estimates the government will run out of cash in June or July, explaining why the price of potential default on US bonds (CDS in the parlance) remains high, while interest rates have risen for 1, 3 and 6 month maturity Treasury bills.
Over the course of the past week, most benchmark 10 year government bond yields have fallen by 0.15-0.25%. Although markets expect a few more rate hikes over the summer from the Bank of England and the ECB, investors are pricing in rate cuts by the Federal Reserve by the autumn. Yes, central bankers are trying to appear hawkish, or at best neutral, about future actions, in view of worrying inflation pressures, whilst the economic data indicates continued growth ahead. However, the markets are focusing on an expected recession, continued banking sector stress, and a potential debt ceiling crisis as the events which will force central banks to pivot away from their rate-rise campaign towards enacting a series of rate cuts.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 3.73 3.27 3.35
UK 3.70 3.51 3.58
Germany 2.52 2.13 2.20
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