The Big Read Monetary policy

Is this the turning point for interest rates?

Many of the major central banks have decided to hold rates steady, but few officials are yet declaring
victory over inflation

Sam Fleming in London, Martin Arnold in Frankfurt and Colby Smith in

Washington NOVEMBER 3 2023

Eurozone central bank governors enjoyed a night out dancing to the theme
song from Zorba the Greek last week after they met in Athens and
unanimously agreed to stop raising interest rates for the first time in 15
months.

The rate-setters could be forgiven for letting their hair down after the
surprisingly harmonious meeting. Even the most hawkish members of the
European Central Bank’s governing council went along with the decision to
forgo another increase in borrowing costs, following a steep drop in
inflation in the single currency area.

“It was the quietest discussion we have had for many months,” recalls
Yannis Stournaras, governor of the Greek central bank, who hosted last
week’s gathering. “It is so obvious that we have tightened monetary policy
enough”.

The ECB was not alone in opting for a freeze. The US Federal Reserve, the
Bank of Canada, and the Bank of England all kept policy unchanged in
recent days, joining central banks in countries ranging from Czech Republic
to New Zealand. Central banks in some emerging markets including Brazil
and Poland are engaged in outright cuts.

The halt in the rate-rising cycle has sparked a flurry of optimism among
bond market investors that leading economies are close to vanquishing the
inflationary upsurge, after consumer price growth more than halved from
its peak levels in economies including the US and euro area. Jari Stehn,
Goldman Sachs’s chief European economist, says there is “a growing view
that the inflation problem is now under control — and I would say rightly
so.”
Yet that celebratory air has been noticeably absent among the presiding
central bankers themselves — leaving aside the revelries in Athens. In recent
days ECB president Christine Lagarde, the Fed’s Jay Powell, and Andrew
Bailey of the Bank of England all continued to insist further increases in
rates remain on the table despite signs that consumer price inflation is
subsiding.

The return of high inflation in 2021 wrongfooted policymakers

and forecasters
CPI inflation (%), with successive IMF forecasts

Actual Apr 2021 Oct 2021 Oct 2023

Source: IMF

That in part reflects a desire to push back against investors who might
otherwise drive down yields and loosen financial conditions, undermining
the campaign to squash price growth. It also reflects genuine uncertainty
over whether the recent data marks a conclusive turning point, especially
given central banks’ past forecasting failures and fears that a volatile
geopolitical environment could throw up fresh price shocks.

Joseph Gagnon, a former senior staffer at the Fed who is now at the Peterson
Institute for International Economics, says central banks are now at an
“inflection point” and that this is a point of minimum — rather than
maximum — confidence in the outlook.

“When you know you’re behind the curve and you better raise rates fast to
catch up, you have a lot of confidence that you’re doing the right thing,” he
says. “But then as you approach where you think you might have done
enough, that’s when you’re less certain about the next move. That’s where
they are.”
Playing it safe
The caution is understandable after central bankers were so badly
wrongfooted by inflation two years ago. The rapid bounceback of consumer
spending following the lockdowns, coupled with the lingering effects of
supply chain shortages, the massive US fiscal stimulus, and the energy price
shocks stemming from the Ukraine war all helped inflame the worst
eruption of inflation for decades among big economies.

It was an outbreak that central banks were slow to recognise until they
realised it risked detaching inflation expectations from their cherished 2 per
cent targets.

Policymakers at the Fed, ECB, BoE and other central banks embarked on a
frenetic succession of rate rises starting around two years ago that has left
borrowing costs in Europe and the US at their highest levels since before the
financial crisis.

In the US, that brutal set of rate rises has helped curb CPI inflation to 3.7 per
cent, far below a peak that neared 10 per cent. Yet the Fed is still dealing
with a surprisingly effervescent economy that recorded annualised growth
of 4.9 per cent in the most recent quarter.

Despite higher prices and shrinking savings buffers, consumer spending has
not yet materially slowed. That is in large measure due to a robust labour
market, although a weaker-than-expected October jobs report on Friday
suggests some moderation lies ahead.
 Markets expect central banks to start cutting interest rates next
year
Policy rates (%)

US (Fed Funds) Eurozone (ECB Deposit) UK (BoE Bank rate)

6
5
4
3
2
1
0

Source: LSEG • Expected path for rates based on overnight index swaps

Speaking at a press conference this week following the Fed’s decision to

forgo a rate rise for its second-straight meeting, Powell was adamant that it
had not closed the door to further monetary tightening. “We’re not confident
at this time that we’ve reached such a stance,” he said in response to a
question on whether rates are now sufficiently restrictive.

Yet Powell did not put markets on notice that any tightening is imminent,
prompting investors to draw their own conclusions, as they shift to
speculating about how soon rate cuts may come.

Powell insisted that the Fed was not even entertaining the idea of when to
cut rates. But increases in long-term rates over recent weeks, driven by
factors including concern about hefty government borrowing, have helped
to tighten financial conditions significantly, bolstering the case that the Fed
can stand still for the time being.
The Fed chair acknowledged that this could obviate the need for the central
bank to take additional steps to restrain economic demand, although much
would depend on how persistent the market moves turned out to be.

Having been widely criticised for being too slow to react to the biggest
inflation surge for a generation last year, the ECB is also — like the Fed —
deeply reluctant to declare victory over inflation prematurely. “The last
thing the ECB wants to do is to make the same mistake by underestimating
inflation for the second time in two years,” says Frederik Ducrozet, head of
macroeconomic research at Pictet Wealth Management.

But the case for European rates having peaked is, if anything, even stronger
than in the US. The eurozone economy contracted 0.1 per cent in the third
quarter, while inflation in the single currency bloc also fell below 3 per cent
for the first time in more than two years.

ECB board member Isabel Schnabel warned in a speech on Thursday that

“the last mile” of the disinflation process “will be more uncertain, slower
and bumpier” and risked being destabilised by “supply-side shocks” such as
the Israel-Hamas conflict. “We cannot close the door to further rate hikes,”
she said.

Slowing economies
Nevertheless, market discussion now centres not on whether further hikes
lie ahead, but rather how soon the ECB’s first cut will come. Economists
expect its rate-setters to wait for clear evidence that inflation has been
tamed before cutting rates. This may hinge on whether collective wage
agreements with unions next spring show an easing of pay growth — a vital
step to bring down core inflation, which excludes energy and food, from its
current level of 4.3 per cent.

If headline eurozone inflation heads sustainably below 3 per cent,

Stournaras reckons a rate cut could come “in the middle of next year”.
For the Bank of England, the dilemma ahead is more nettlesome. The bank
downgraded its views of both UK output and supply in its November
forecasts on Thursday, as it held rates at 5.25 per cent, warning that pay
pressures remained more resilient than it had expected and that
unemployment may have to rise further than expected to bear down on
prices.

Its outlook was grim, portending flatlining growth, coupled with above-
target inflation until late in 2025. Bailey said his rates committee reserves
the right to lift rates again if needed, but many investors see a further
increase as highly unlikely given the weakness of the economy and signs of a
cooling labour market.

Tiffany Wilding, managing director at Pimco, says that while headline

inflationary trends in Europe have been one or two quarters behind the US,
economies were now heading in the right direction on both sides of the
Atlantic.

How much labour

market pain do you
need to really get
[inflation] back down?
But she adds this does not necessarily mean that they are entirely out of the
woods, in part because the main reasons for the decline in inflation are
“pandemic-related effects fading” — for example the ending of supply chain
snags and an ebbing tailwind from fiscal policy.

“What central banks are still a little bit worried about is that once we have
these pandemic-related distortions on inflation that fade, where is the
underlying trend in inflation?” she asks. “How much labour market pain do
you need to really get [inflation] back down?”

Given a volatile geopolitical environment that threatens to throw up fresh

supply shocks, and the prospect of fragmenting supply chains amid rising
trade tensions, claims that inflation has been definitively quelled could
quickly look like wishful thinking.

“I don’t think that any of them are ready to put up a banner that says
‘mission accomplished,’” says Seth Carpenter, who previously worked at the
Treasury department and the Fed and now at Morgan Stanley.

“I think the past two-and-a-half years have shown just how difficult
forecasting can be, and I do think there is a sufficient dose of appropriate
humility across central bankers about how hard it is to know for sure where
things are going.”

Additional reporting by Mary McDougall in London

Data visualisation by Keith Fray

Copyright The Financial Times Limited 2023. All rights reserved.