We reiterate our statement from last quarter that the major central banks are well advanced on the path of moving to a tight monetary regime through raising interest rates and starting QT (quantitative tightening). The Fed may well have deliberately adopted a hawkish tone (using the labour market as an excuse) to ensure that the market does not get ahead of itself due to the increasing level of discussion over a pivot (i.e., a change in direction). The amusing aspect of all of this is that the Fed has already eased off on the pace of monetary tightening by shifting to a 50 bps rate hike from 75 bps, and it will inevitably move to 25 bps fairly soon, if not at the next meeting. The hawkish tone should therefore be tempered by their actions.
As things currently stand (in light of recent comments), we are set for divergent policy across the five major central banks.
- The Fed will raise interest rates by potentially another 50-75 bps, but the bulk of tightening is now done. If they go into an aggressive tightening mode (despite lower growth and inflation), the risk of a harder landing will rise with the prospect of a period of deflation. This would represent a potential policy mistake following last year’s mistake.
- The Bank of England policymaking committee already has a three-way split, as two MPC members voted for no change in December and one voted for a 75 bps hike (with rates raised by 50 bps). Similar to the Fed, the BoE has delivered the bulk of monetary tightening and is likely to hit the pause button either late this quarter or in Q2. Given the prospect of a recession this year, lower inflation, tight fiscal policy, and Brexit-related challenges, the likelihood of a weak growth profile may well force the BoE’s hand later this year.
- The Bank of Canada is very close to hitting the pause button, stating that it will be “considering whether the policy interest rate needs to rise further to bring supply and demand back into balance and return inflation to target,” which is a distinct shift from the previous statement that it “expects that the policy interest rate will need to rise further.”
- The ECB stands out alone right now as it delivered the expected 50 bps rate hike in mid-month (a step-down from 75 bps), but the surprise was the extreme hawkishness. The council said that it “judges that interest rates will still have to rise significantly at a steady pace to reach levels that are sufficiently restrictive.” It also announced QT details, which were also on the hawkish side. The market has factored in another two 50 bps hikes, taking the deposit rate to 3% and potentially rising toward 3.75% later this year. Whether the ECB gets to that level given the easing in inflationary pressures is a moot point, but clearly the ECB could well be the one that could be volatile.
- The Bank of Japan surprisingly lifted the yield curve control target range from 25 bps to 50 bps (+/-) in mid-December, while also stepping up bond purchases from 7.3 trn to 9.0 trn per month. Their stated intention is to improve the functioning of the JGB market, but could also be an attempt to try and move away from negative rates. It is a confused policy stance as inflationary pressures and global growth are already easing, and the domestic factors contributing to a prolonged period of low growth are still in play. A stronger yen (as already seen) will only add to the downward pressure on inflation. We are also heading toward a new BoJ governor, and it may just be that the new incumbent is being given some room for manoeuvre. The market does not expect a rate hike for some time, but there is still a chance that the new governor will make a token move in the spring.
In a sense, we would ask investors to focus on underlying economic developments and not be diverted by central bank rhetoric, as they are desperate to regain credibility. But of course, just because they were too slow last year to tighten (a mistake), they could make another mistake by over-tightening. We will certainly have more concrete evidence by Q2 to judge how quickly we may revert to the pre-COVID period of low growth, low productivity, demographic challenges, and potentially target inflation.
To find more about the latest house views from London & Capital’s Investment Desk, read the full AndPapers Q1 2023 here.