What Did the Central Bank Heads Say at Sintra?

Summary

• The ECB’s annual conference in Sintra offered various opportunities to hear from central bankers and academics.
• The Central Bank governor panel, which featured the heads of the European Central Bank (Christine Lagarde), Federal Reserve (Jerome Powell), Bank of England (Andrew Bailey) and Bank of Japan (Ueda Kazuo) was one of the most watched events.
• We provide a brief overview of the comments made.

There is still ground to cover, with a hike in July very likely, if baseline foreacsts hold . In September, the ECB will have a lot more data, and new forecasts.They are not currently considering a pause. Core and headline need to both be watched. Not yet enough tangible evidence that underlying inflation is coming down. Do not see a recession ahead, but economy is stagnant with a weak manufacturing outlook. Lagarde also noted that there is no way that any of the CBs would consider changing their inflation target at this stage.

There are three steps to lagged transmission effects: (1) financing terms and markets respond pretty fast (rates & volume of loans); (2) investment by corporates and households reduces – it is a very diverse market in EZ and this transmission is slower than in the past; (3) transmission to inflation.

The ECB continue to watch political (Russia) risks on basis of supply-side risks. What happens in China and US will also affect Europe. Elsewhere, European banks are in good shape. Additionally, it is time for governments to roll down energy support measures and shift path to sustainable public finances. Lastly, the reduction in the balance sheet is occurring naturally via TLTRO repayments and APP wind-down.

The UK economy is much more resilient than expected. And because of the labour market and inflation data, the BoE decided they needed to make a strong move (50bp). Their MO is: if they believe 25bp then another 25bp is needed, then may as well do 50bp.

Headline inflation is coming down markedly this year and we will see some quite discrete drops ahead (as pricing effects play a role). Meanwhile, the labour market is very strong, but it is smaller than it was pre-Covid –  Brexit is not such a driver of this tightness, it has more to do with retirement. Looking forward, firms are planning to retain labour.  Recession risk fell with the fall in energy prices.

The transmission of monetary policy is slower due to longer mortgage fixes, and MPC needs to consider how much tightening has yet to feed through. Over the next year lots of fixed rate mortgages will be refinanced.

Regarding market pricing looking for more hikes: ‘well we’ll see’. Moreover, Bailey was surprised that the market is looking for such a short peak in rates. From his point of view, the UK banking system is resilient – supporting UK economy, not the other way round. Additionally, he welcomes fiscal spending to deal with labour market tightness. Lastly, on QT they justified the active selling on the basis that as passive would be too slow given duration of holdings.

Headline inflation is high, but underlying inflation is less than +2% YoY. Meanwhile, the rate of increasing wages is now running at about +2% YoY. Ueda stated that if you want inflation at +2% YoY then you want wages far above +2% YoY. Unsurprisingly, the BoJ are monitoring the yen. Looking forward, inflation should come down into the year-end due to falling import prices but the BoJ expect it to rise back up in 2024. The BoJ can start to unwind dovishness if they become more confident of this 2024 outlook playing out.

The Japanese economy is doing fairly well, driven by pent-up demand. Ueda does not see risk of other central banks overtightening. In Japan, inflation expectations are rising but have yet to surpass 2%. Meanwhile, Japanese stocks are rising sharply, probably due to more positive investor view of the economy. US/China tension driving re-onshoring, which is helping Japan in the short-term, but in the longer-term could cause inefficiencies.

The Fed is set on maintaining the Fed funds rate at a high level. More tightening power is coming through as rates have not been restrictive for very long so far. The labour market is really strong. A majority on FOMC wanted two or more hikes this year but with sisks more balanced both ways, the Fed decided to pause.

Breaking core inflation into Powell’s favoured three categories:: 1) goods – they are improving; 2) housing – disinflation is good (will take 8-12 months to feed through fully); 3) non-housing services – seeing less progress. Non housing services is wage driven. Have not seen much progress on this so far – so need to hold rates high. Powell sees a path for labour market tightness to fade without mass unemployment. The risk remained tilted towards doing too little. Failure to restore price expectations is a big concern. With regards to commercial real estate (CRE), large banks do not have large exposure while supervisors are talking to banks around the risk. However, CRE was not one of the reasons they were cautious last meeting. Bank stress seen earlier in the year takes time to feed into credit tightening – and that is in the back of their mind. The Fed has to watch and see on transmission, it could be faster or slower than in the past. Lastly, Powell is not too bothered about individual market performance, the Fed are watching broad financial conditions.

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.

Photo Credit: depositphotos.com

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