Is the Central Bank Train Coming to a Halt?
It’s been a significant start to the year, with continued central bank action and market volatility.
While 2022 was characterised by tightening central bank policy, 2023 is already looking like it will mark the end of this cycle – but what are the risks to this scenario?
The Federal Reserve
The Federal Reserve was first to tighten among the big three central banks, and it looks like it will be the first to come to a halt. Jay Powell delivered a 25bp hike this week, and the guidance is potentially for “a couple more”. But what is the state of the US economy, and is this pause warranted?
We’ve written before that the main reason why the Fed tightened hard and fast was inflation shooting higher. This remains the main problem and the leading reason for hiking rates. However, we have now seen six consecutive months of falling inflation – down to 6.5% YoY from a peak of 9.1% – and it’s broadly expected to keep falling. For this reason, Powell must surely feel more at ease with a near-term pause, and for inflation prospects going forward. This inflation drop should be accentuated by the fact that the CPI YoY calculation has been changed for February (with the change bringing more downward pressure to the reported number).
Aside for inflation, the US economy is not looking in great shape, with leading indicators flashing red and housing slowing down. One could argue that the only good thing going for the economy is employment, which remains resilient. We could argue that the quality of employment has been dropping, but the fact remains that we are near historical lows in unemployment.
Where does this leave us for the Fed, going forward? There are probably two main risks – one to the upside and one to the downside.
- The first risk is that although inflation will likely continue to drop in the short term, second-round factors might push it to the upside once again. This will bring the Fed to a difficult position, having paused their tightening cycle and suddenly needing to restart it.
- The negative risk is a deterioration of the jobs market, which is a probable scenario, and which could accelerate the economy’s downturn. In this eventuality, the Fed will likely have to start easing conditions, matching what the market is currently pricing.
The European Central Bank
The European Central Bank was late to start hiking rates, and it will naturally likely continue after the Fed has paused. They hiked 50bps this week, with guidance indicating a couple more 50bps hikes before the pace gets reduced to a halt.
The Eurozone economy is fragile, with high inflation being a continuing problem. In this respect, the Eurozone is more vulnerable than the USA, as their dependence on foreign oil and gas is pronounced. Elsewhere the Eurozone economy is in a similar state as the USA, with leading indicators showing weak readings but employment still being robust.
Christine Lagarde faces a difficult task, with inflation remaining sticky but the economy also showing signs of weakness. Lagarde will be very aware that the periphery can be particularly vulnerable – as has been the case during every major crisis of the past years – and bond yields of the weaker Eurozone countries can shoot higher very quickly.
The most likely scenario in my opinion is that the ECB will follow the Fed’s example and slow down tightening, eventually bringing it to a halt, sooner rather than later.
Bank of England
The Bank of England also hiked 50bps this week, as it continues to fight inflation pressures. However, for the past couple of decades the main BoE theme is to take the dovish option whenever it’s available. For this reason, it’s most likely that the BoE will err on the side of caution when it comes to tightening, slowing down earlier than they potentially should. Chief Economist Pill said today that “…it’s important not to raise borrowing costs too high”, and that “…we have to recognize that we have done a lot of monetary policy already”.
We already have a 7-2 split in the past two MPC meetings, with two members voting for no change in rates. This could easily shift further and lead to a pause in tightening in the near future.
We are undoubtedly near the end of the current tightening cycle for all three major central banks – the Federal Reserve is leading the way, with the BoE and ECB close behind. There is a risk for inflation to halt its downturn, and this is the scenario that would cause central banks to either pause later, or to revert to a more hawkish stance.
Another risk involves the labor market, which is the last economic indicator to remain strong up to now. Any downturn will be seen as very negative for the overall economic environment, and it will certainly affect central bank action.
They say “don’t fight the Fed”, and this is probably valid for the ECB and BoE as well. The current trend is for central banks to be more dovish, and this will likely continue in the short term, especially if the upcoming US CPI number disappoints. The market is pricing rate cuts in late 2023 for the Fed and this is probably too aggressive, but in the short term there will probably be no reason for this to change.
These are difficult times, with economic data being volatile enough to cause big moves in the markets – trade carefully.
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