Have Central Banks Hit a Fork in the Road?

Summary

• The Fed, BoE, and ECB all hiked by 50bp last week, but with profoundly different tones:
  • The Fed unanimously voted to hike by 50bp, with Chair Powell indicating further tightening would come and that the terminal rate may need to be higher than previously suggested.
  • The ECB followed suit, with a strongly hawkish forecast update and wording to support our assertion that significantly more hiking is necessary – more than the market is pricing.
  • Meanwhile, the BoE hike was tinged with dovishness. Two members shifted to vote for a pause, with only one looking for a further front-load (75bp).

Market Implications

• The monetary policy environment adds to our conviction for a lower BoE terminal rate and higher ECB rate (than priced).

Introduction

It was a heavy week for monetary policy. First, we got the Federal Reserve (Fed), then the Bank of England (BoE), and finally the European Central Bank (ECB). In what was probably 2022’s last main trading week, these three have largely directed the market mood into the New Year.

Fed: Hawkish Tilt

Read Dominique’s review.

The Fed hiked 50bp to 4.25-4.50% on Wednesday with a hawkish twist despite more dovish forecasts than expected. Chair Jerome Powell resisted the notion that undershooting CPI prints in October and November meant inflation was under control. Instead, he left the prospect open for a higher terminal rate than the Fed was previously assuming (5.1% in 2023, from 4.6% previously, Chart 1). Dominique continues to expect an 8% terminal rate.

BoE: Growing Signs of Dovishness

As I had expected, the BoE hiked the Bank Rate by 50bp to 3.50% with a dovish twist. There were two votes in the Monetary Policy Committee (MPC) to pause (I had expected only one) and only one vote for 75bp (as I had suspected, External Member Catherine Mann was alone there).

The December meeting was no time to upend the policy boat. That time will come in February. But, still, the minutes contained further dovish hints. First, it is now clear the BoE considers the government’s Autumn Statement to have added little additional medium-term inflation. Second, it clearly now sees labour market tightness as having peaked, with risks to both sides on wage growth.

The BoE’s assessment aligns with my long-held view that the UK labour market is turning over (Chart 2). I think the data could deteriorate rapidly when it goes given activity rates only need rise a little to significantly raise the unemployment rate. Ahead, declining employment will compound the pressure on UK households from energy and retail prices and mortgage rate rises.

Given these pressures, there remains a strong rationale for the BoE to push back on market pricing for hikes at its next meeting in February. That would mean significantly less hiking than the market is pricing (Chart 3).

ECB: Room for Lots More Hiking

Finally, in line with my expectations for hawkishness, the ECB hiked 50bp to 2% and pushed back strongly on pivoting. ECB President Christine Lagarde did not pull her punches, stressing more 50bp hikes ahead and that the ECB had more ground to cover than the Fed.

The updated forecasts support the need for a lot more hiking ahead. The expected core-CPI rate in 2023 is now 4.2% – more than double its target (Chart 4). By contrast, the market is pricing the deposit rate to be just over 3% at that time (Chart 5).

The ECB also announced the start of its balance sheet reduction (quantitative tightening, QT). This is set to take place from March 2023 at a rate of €15bn – in other words around half of maturing assets would not be reinvested from then – scheduled to be re-evaluated from end-Q2. The rationale for the QT remains to normalise the ECB’s policy away from the ultra-loose setting it has been on since the financial crisis (exacerbated by COVID).

We have long thought the ECB will need to hike more than market pricing. I think the press conference and subsequent policymaker comments have confirmed this to be their plan. I believe the ECB intend to hike up to 4%, or higher. However, I doubt they will be able to reach such levels before market conditions cause them to pause. 3.5% seems more achievable after 50bp at the next three meetings.

The Market Implications

We expect the ECB and Fed to hike more than the market is pricing, while the BoE looks likely to underdeliver.

Excluding the market dislocation from the UK’s ‘fiscal event’, the interest rate differential has largely driven EUR/GBP this year. Consequently, if our central bank expectations come to pass (suggesting a peak differential of around 50bp), the pair could rise further (Chart 6). By contrast, GBP/USD has been less driven by interest rate differential (Chart 7).

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)