15 December 2023
To pivot or not to pivot, that was the question. This week we saw the meeting of the Bank of England, European Central Bank (ECB) and the US Federal Reserve (Fed). Whilst the decision on interest rates was the same, with all three remain on hold, the guidance provided in terms of the future certainly revealed some difference in expectations.
In their statement which accompanied the decision, the Bank of England revealed that they had voted 6 to 3 in favour of doing so, with 3 members preferring to hike increase the base rate by 0.25% to 5.5%. The 3 thought that this was the best course of action due to continued tightness in the labour market and persistent inflationary pressures. Whilst it is still the Bank’s central forecast that inflation will be back towards the 2% target by the end of 2025, they acknowledged that inflation pressures still persist. Therefore, they foresee that restrictive monetary policy could be needed for some time.
In the US, meanwhile, the market interpreted the Fed as being much more aggressive in terms of the potential interest rate cuts in 2024. Indeed, the latest dot plot chart, a summary of expectations of the individual Fed committee members, suggests that we could see three rate cuts, each of 0.25%. Whilst this is the median of expectations, there again is a relatively wide range in forecasts, with one member expecting a rate of 3.75%-4.00% by next year end, whilst two others predict that the Fed Funds Rate will still be unchanged from the current level of 5.25%-5.50%. There clearly remains divergence on the future path of inflation.
Despite this variation, the market is all set for the green light for cuts next year. The exact timing of the first cut, the scale of potential cuts, and where inflation may be at the end of 2024, you could argue, remains guess work. However, the direction now looks more decided. As a consequence, we saw significant market moves. In the US Treasury market, we saw 2-year gilts fall from a closing level of 4.735% on the 12 December to 4.428% at the time of writing. At the same time, the 10-year yield fell from 4.21% to 3.91%. There was also a positive reaction from equity markets. Despite the more cautious stance from the Bank of England, UK mid-cap stocks closed 3% higher on Thursday, in the hope that lower interest rates moving forward will protect the economy from a more protracted slowdown. Larger company share prices also responded positively, but to a lesser extent.
So, are the Federal Reserve justified in their latest guidance? It is well documented that the US labour market remains tight, with a lack of appropriately skilled workers and demographics meaning that jobs continue to be added on a monthly basis. However, there are some indicators out there which suggest that the Fed could be on the right path. Firstly, there is US housing rent inflation. This is a large proportion of the US consumer price index (CPI) basket, accounting for over a third of the CPI basket as of December 2022. The Zillow rent index, which typically leads CPI by 6-12 months, has turned down significantly. If the close correlation between the two remains in place, the CPI will be heading in the right direction.
Another contributor to higher inflation was money supply. Monetary and fiscal stimulus in response to the pandemic to support the economy, which had ground to a halt, meant the system was flooded with money. This inevitably found its way into the economy as it reopened. Year on year this reading is now in negative territory.
A further contributor to inflationary pressures were global supply chain issues during COVID. The Federal Reserve Bank of New York Global Supply Chain Pressure Index shows how these pressures reached an unprecedented level. These have now fully dissipated, meaning that supply issues, in aggregate, no longer exist, and therefore should not lead to upward pressure on prices.
There are undoubtedly risks that we continue to see volatility shocks around inflation. For example, if we were to see the re-emergence of an energy crisis, this would inevitably feed through into headline figures. However, this would be more of a supply issue rather than a demand issue, and the extent and timing of an issue is almost impossible to predict. After this latest meeting the Fed has potentially backed itself into a very narrow path of journey, where you could argue that the market now has a greater chance of being disappointed if the central bank were to deviate from its indicated path. For now though, the market likes it!
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