June 16 2023
This week was another big one for central banks, with both the European Central Bank (ECB) and US Federal Reserve meeting to set interest rate policy. As expected, the ECB rose by 0.25%, bringing the rate of main financing operations to 4%, the deposit rate to 3.5%. This was the eight consecutive rate hike and was made despite the euro area officially being in recession. It would appear however that the central bank is not done hiking yet. Central bank president, Christine Lagarde, in her post meeting statement, suggested that the ECB still had more work to do and therefore would likely continue to raise rates. Asked if she believed that the bank was now done, the response was “no, we are not at destination.” Lagarde said that the bank “will continue to hike at our next meeting. So we are not thinking about pausing, as you can tell.”
Whilst inflation in the area fell in May, year on year, to 6.1% from the previous reading of 7%, this will still be uncomfortably high for the rate setting committee. This reading was in line with forecast but the same cannot be said for wage growth, posting an increase of 4.6% year on year for the first quarter. Whilst this was lower than the previous reading of 5% but higher than the consensus forecast 3.3%.
In the US meanwhile we saw the Federal Reserve take the decision to pause hiking, keeping the federal funds rate at 5%-5.25%. This was as expected. The pause was made to allow for a period of assessment, taking into consideration the increases which we have already seen. They, like the ECB, believe that further hikes appear warranted. Chair Powell admitted that risks to inflation are still to the upside. Whilst they paused this time, the median expectation for the year end, taken from the latest dot-plot, suggests that there are likely two more hikes from here. The forecast range is relatively narrow too.
Looking into 2024 the committee expect that rates will start to fall, but the median still points to a 4.5%-4.75% range, perhaps higher than investors expected. You could question whether the median actually means that much, given the wide range of forecasts that were made, ranging from a low of 3.25% to 5.75%. Clearly there are divergent opinions amongst the ranks regarding inflation and growth expectations and the path which the central bank will need to follow next year.
Whilst we need to wait till the 22nd June for the Bank of England decision, the expectation is that another 0.25% hike will be seen, taking the base rate up to 4.75%. Markets are now pricing that we could see rates as high as 6% in the UK. Whilst they too are expected to fall as we move through 2024, the market does not appear to believe that they move quickly, quite the opposite. Things change of course, but as long as inflation remains a burden on the central bank, it makes you wonder just how much flexibility they will have.
One saving grace for reducing inflation, in the US at least, is the expected contraction in money supply. Over history there has been a close relationship between this and inflation. If this relationship were to hold true and money supply were to move in the expected direction, this could help the US Federal Reserve’s cause in bring inflation under control. The question is, is this correlation or causation? As we have said before, there is difference.
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