Central banks are catching up

28 November 2022

After a run of large interest rate rises over the summer, central banks seem likely to ease the pace of monetary tightening. We’re not there yet, but much of the heavy lifting in terms of rate rises in this economic cycle has happened.

In early May interest rates in the US and UK stood at 0.5% and in the euro area at -0.5%. Monetary policy looked out of line with inflation which was running around the 8.0% mark.

The ensuing six months have seen the most rapid tightening of western monetary policy in more than 30 years. Since the 1990s central banks have tightened policy slowly, usually raising rates by 25bp or, less frequently, 50bp. It is a measure of the scale of the inflationary challenge today that the Federal Reserve, which last raised interest rates by 75bp in 1994, has implemented four consecutive 75bp rate hikes since May. US rates have risen from 0.25% to 4.0% in nine months.

It’s the same story of catch up elsewhere. The European Central Bank (ECB), which had only ever raised rates in 25bp or 50bp increments, raised rates by 75bp in September and then again in October. The UK was the first of the major central banks to raise rates last December. UK rates have risen from 0.25% to 3.0%, with the latest increase being 75bp. The Canadian and Australian central banks have gone faster, raising rates in 75bp and 100bp increments.

Outside Japan, western interest rates are at the highest level in 15 years. Tighter policy is slowing growth and inflation looks at, or close to, a peak. Monetary policy no longer looks desperately behind the curve.

In the US supply and demand seem to be moving closer to balance. Inventories have recovered from the rock bottom levels reached last year. The Purchasing Managers’ measure of unfilled orders hit record highs last year but is back to normal levels. Supply chain problems have moderated. The price of most commodities – oil, gas, metals, agricultural products and semiconductors – have fallen from their peaks earlier this year. With the consumer goods boom petering out and commodity prices easing US goods inflation has fallen away sharply. In October consumer price inflation came in below market expectations, fuelling hopes that US inflation is at or near a peak.

The minutes of the Fed’s November meeting released last week suggest a change in mood among US policymakers. A “substantial majority” of the rate-setting committee now favours slowing the pace of US rate rises.

Financial markets expect the campaign of rate rises to continue, but central banks to move in smaller increments with the Fed, Bank of England and Bank of Canada raising rates by 50bp in December and Australia’s central bank hiking by 0.25%.

The ECB is the one major central bank that still seems to be in catch-up mode. Euro area inflation stands at 10.6%, a bit below the UK and higher than in the US, yet euro area rates of 1.5% are less than half levels in the US or UK. Markets expect the ECB to be the outlier among central banks next month, raising rates by 75bp at their meeting on 15 December.

Next year financial markets see US rates peaking at 5.0%, UK rates at 4.75% and euro area rates at 3.0%. (Market expectations for the peak in UK rates surged to over 6.0% following the mini-budget in September but with the withdrawal of the package and a tightening of fiscal policy have since fallen back sharply.)

Markets think that US rates now stand at 80% of their expected peak (4.0% vs 5.0%), UK rates are at 63% of their peak and euro area rates are at 50% of the expected peak.

Over the last 50 years the US and UK economies generally enter recessions with interest rates at or near their peak. The lion’s share of rate rises precedes the downturn. With the onset of recession, contracting activity creates spare capacity and inflation starts to ease. In the past central banks have therefore tended to lower rates during the recession. This cycle may prove to be different but were it to conform to this template central banks would reduce rates later next year.

Unfortunately, inflation is not currently at levels consistent with an easing of policy. Some drivers of headline inflation have moderated, but that respite could be short-lived. Commodity prices are volatile and supply bottlenecks remain. Most importantly, underlying price and wage pressures are strong.

Central banks need to engineer weaker growth to create spare capacity in the economy. That means a weaker labour market and higher unemployment. Despite the recent campaign of central bank rate hikes, unemployment rates in the US, UK and the euro area are running close to 50-year lows.

Slowing activity will weaken labour markets over the coming months. My hunch is that interest rate reductions will follow, though probably not until the second half of next year.

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OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week up 1.4% at 7,487. UK equities continued to rise last week as interest rate expectations fell and the pound gained over the dollar.

UK economics

The UK economy is expected to shrink by 0.4% in 2023, making it the poorest performer in the G20 except for Russia, according to the OECD
UK economic activity shrunk in November for a fourth consecutive month, according to the S&P Global/CIPS UK composite purchasing managers’ index
Data from Barclaycard Payments show Black Friday sales transactions rose 3.2% on last year
Reports of the UK considering a Swiss-style agreement with the EU were dismissed by UK prime minister Rishi Sunak
UK five-year mortgage rates fell below 6% for the first time since the mini-budget as interest rates expectations have fallen
The UK’s largest transport union RMT and the Royal College of Nursing announced strikes as talks with Network Rail and the NSH fail, respectively

Global economics

European gas prices rose last week following Russian threats to reduce supply, reigniting fears of an energy shortage in Europe
Business confidence in Germany unexpectedly rebounded from a two-year low in November, according to the Ifo Institute
German industrial producer prices fell by 4.2% in October, the first decline in two years thanks to a drop in wholesale energy prices
The Spanish government is set to introduce mortgage relief measures for vulnerable families to help with higher interest rate costs
Italy plans to increase windfall taxes on energy companies to finance support for households and firms struggling with higher energy prices
US jobless claims hit 240,000 – higher than expected and the highest level since August – suggesting the US labour market is starting to cool
Most US Fed officials back a slower pace of interest rates hikes, according to the minutes of their recent meeting
US freight rail workers voted to reject a pay deal negotiated with the help of the Biden administration, adding to fears of a nationwide strike. Such a strike would create new supply bottlenecks

Business

The European Commission set out plans to cap gas prices as well as impose consumption cuts to ease pressures on European economies
The Times reported that UK warehouses owned by high-street fashion retailers are filling up with unsold stock as supply-chain pressures ease and consumers reduce spending
Legal & General’s chief executive Sir John Kingman blamed the mini-budget for the pension fund’s liquidity crisis
Cryptocurrencies fell last week following market turmoil sparked by the bankruptcy of the crypto exchange FTX as fear of contagion spreads
The FT reports that rare whisky prices have surged as investors seek refuge in tangible assets
The UK Financial Conduct Authority warned against the gamification of trading apps as it can lead to “gambling-like investor behaviour”
The UK Competition and Markets Authority opened a probe on the chipmaker Broadcom’s proposed $69bn acquisition of software group VMware
Virgin Money reported a 40% increase in pre-tax profits thanks to higher interest rates and reported that credit quality in the UK remains “robust”
PC maker HP announced 6,000 job cuts in the next three years to increase earnings by the end of 2025
Jaguar Land Rover announced it would reduce production at its Solihull and Halewood factories until the spring due to a computer chip shortage

Global and political developments

China faced widespread protests against the government’s zero-COVID policy
The UK’s Supreme Court ruled that a new Scottish independence referendum would have to have Westminster’s approval
Ukraine’s state energy firm Yasno announced that rolling blackouts will continue until March due to Russian missile strikes on its power plants
Hungary announced it would not vote to ratify Sweden and Finland’s admission to NATO until next year
Turkish president Recep Tayyip Erdoğan threatened to expand military operations against Kurdish militants in northern Syria
The UK Labour Party is considering replacing the House of Lords with an elected chamber if elected, as well as strengthening devolution in the UK
Brazil’s far-right Liberal Party announced it would challenge the election it lost to the leftist Luiz Inácio Lula da Silva

And finally… minutes after loading a plane, security staff at JFK Airport freed a tabby cat that had somehow managed to get into a checked-in suitcase – letting the cat out of the bag

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