Jeremy Sterngold, Head of Fixed Income
While the early part of the year was characterised by a hawkish shift across most of the developed markets central banks, the Russian invasion of Ukraine and the lockdowns imposed in China due to their zero COVID-19 policy have complicated the outlook further.
As the economy recovered post-pandemic, the view from central banks at the time was that most inflationary pressures were likely to be fleeting in nature. While there is some evidence of that in certain pockets of the economy (namely second-hand car prices, which started to turn lower after an astonishing run), other parts have shown some persisting price pressure.
Labour markets have tightened as economies had to adjust to rapid changes over the past two years. The geopolitical developments and rising energy costs are likely to put further strain on supply pressures. Given these circumstances, central banks have now moved to curtail demand to take pressure off the supply-side of the economy, something that was very clear during the central bank meetings that took place this week.
Reserve Bank of Australia hikes rate for first time in eleven years
While most eyes were focussed on the US Federal Reserve (Fed) and the Bank of England (BoE), it was first the turn of the Reserve Bank of Australia who opted to hike rates from 0.1% to 0.35%. This was ahead of expectations, as rates were widely anticipated to move to 0.25%. Although a relatively modest hawkish surprise, it demonstrates that the general direction of travel for rates globally has moved higher of late.
The Fed continues to tighten policy
Turning back to the key events, much of it unfolded in the way we expected, and have previously written about: (Are the Federal Reserve and the Bank of England on a similar trajectory?). The Fed signalled its intention to raise rates by 0.5% quite clearly ahead of the meeting, so raising base rates by its largest increment in 22 years had little impact. Between the March and May meetings, many members of the Fed clearly earmarked their desire to frontload this hiking cycle, considering a series of 0.5% hikes.
Although the market had come to terms with back-to-back increases of such a magnitude, investors were on edge following a suggestion by one of the most hawkish members, James Bullard, of a 0.75% increase. During the press conference, however, Chair Jerome Powell indicated that, while they intend on hiking rates a couple of times by 0.5%, they had not discussed the possibility of a 0.75% increase. Furthermore, the vote to increase rates by 0.5% was unanimous.
The Fed also announced that they would start the process of unwinding its balance sheet holdings of Treasuries and Mortgage-Backed Securities in June. For investors who had become used to hawkish surprises from central bankers, being in line with expectations offered some relief. Markets initially rallied, until the BoE gave them pause for thought.
Reluctant rate rise from the Bank of England
While the Bank of England hiked rates by a further 0.25% to 1%, reading through their commentary I see it more as a reluctant hike. Allow me to elaborate: the BoE appears to be stuck between a rock and a hard place.
On the one hand, the labour market is showing signs of being rather tight, with risks of wages pushing materially higher. On the other hand, given the spike in energy costs following the Russian invasion, they are now assuming energy prices will rise by a further 40% in October when the Ofgem price cap is recalculated. As such, they now forecast inflation to peak above 10% in the fourth quarter of the year. This means the cost of living crisis will bite even harder, just as winter falls and people may be forced to make hard decisions on what to cut down on in order to heat their homes.
Given the extraordinary increases in the cost of living, with food prices under pressure too, the BoE is now forecasting the UK economy to shrink by 0.25% in 2023. Ideally, the BoE would like to support households in the economy but, given it cannot be this targeted, it is trying to calm down inflationary pressures to ensure that the less well-off in society, and those on fixed incomes, do not see their real incomes decline further.
The reaction to the decision and its gloomy forecasts saw the pound fall by over 2% versus the US dollar yesterday. Further weakness will only exacerbate the problems of inflation as the UK is heavily reliant on imports. We should therefore continue to expect some tightening from the BoE into a slowing economy.
Central banks’ outlooks diverge
While the Fed continues to be confident that its accelerated pace of rate hikes will not result in the US economy contracting, the BoE forecasts a modest one subject to the swings in energy commodities.
These widely different outlooks have given investors reason to reflect. Ultimately, the war in Ukraine and the lockdowns in China have, in the short term, increased inflationary pressures at the expense of growth. These are not things that central banks can control, they can only moderate demand for goods, services and labour within the economy. Nevertheless, given the short-term outlook, it will be more difficult for central banks to be even more hawkish than what is currently being priced in.
