Central bank heads Jerome Powell and Christine Lagarde struck a hawkish tone this week to temper market enthusiasm for expected policy pivots, however, outlooks from central banks and asset managers indicate interest rate pathways have been well-telegraphed.
Even after the US Consumer Price Index (CPI) reading came in below expectations for the second consecutive month and the Federal Reserve slowed the pace of its interest rate hikes to 50 basis points (bps) a day later, Chair Powell warned “risks to inflation are weighted to the upside”.
In his press conference on Wednesday, he said inflation remains “well above” the 2% target and despite recent CPI readings, “it will take substantially more evidence to give confidence that inflation is on a sustained downward path”.
He added more anchored inflation expectations are “not grounds for complacency” and the Fed is “taking forceful steps to moderate demand”, which may mean economic slowdown to meet target inflation levels.
“Reducing inflation is likely to require a sustained period of below-trend growth and some softening of labour market conditions. Restoring price stability is essential to set the stage for achieving maximum employment and stable prices over the longer run,” he continued.
“The historical record cautions strongly against prematurely loosening policy. We will stay the course, until the job is done.”
Similar messaging came from European Central Bank (ECB) President Christine Lagarde after also slowing the policymaker’s rate of hikes to 50bps despite lagging the Fed’s interest rate pathway.
She said the governing council had “more ground to cover, we have longer to go” and “the ECB is not pivoting” while promising two more 50bps rate hikes in February and March meetings.
On the latter, announcement, Luke Bartholomew, senior economist at abrdn, said while the 50 bps hike was “widely expected”, the messaging “accompanying the decision was strikingly hawkish”.
“Lagarde seemed to want to explicitly manage market expectations towards a higher terminal rate. It is unusual for Lagarde to attempt to steer markets quite so forcefully and goes to show the urgency of the point the ECB is making.”
However, Bartholomew and others are unconvinced the ECB and others will maintain such a course as economic warning lights begin to flash.
“If the economy falls into a deeper recession than the ECB is forecasting, we think rates are unlikely to rise quite as aggressively, with economic weakness taking care of the underlying inflation problem.”
In its 2023 outlook, BlackRock said central banks such as the Fed had chosen “crushing demand” as their tool to fight 40-year-high inflation and this could mean a recession is “foretold”, however, the world’s largest asset manager added policymakers will ease off on monetary tightening in such a scenario.
“Signs of a slowdown are emerging. But as the damage becomes real, we believe [central banks] will stop their hikes even though inflation will not be on track to get all the way down to 2%,” BlackRock argued.
Even with the hawkish tone from central bank leaders, the expected 50bps hike in the Fed funds rate in February next year and the two hikes forecast by Lagarde would just take the policymakers’ terminal rates – assuming these are their last hikes – to being in line with market expectations.
Indeed, BlackRock, PIMCO and JP Morgan all agreed the Federal Reserve’s terminal rate would be in the 4.75-5% range, whereas it currently stands at 4.25-4.50%.
Similarly, Deutsche Bank suggested the ECB’s terminal rate would be 3% by mid-to-late Q2. It currently stands at 2%.
The Fed and ECB’s rhetoric show they know their messaging impacts market sentiment and might temper some giddiness in this case. Alternatively, it could also be some projection of guilt for the roles they played in catalysing loose monetary conditions – prior to idiosyncratic pressures such as the Russia- Ukraine crisis.
As Thomas Becket, CIO at Punter Southall Wealth quipped: “These monetary heroes are looking to slay the inflationary dragon, which they themselves were at least partly responsible for unleashing on the world.
“Yes, the irony that we are letting those same arsonists who started this fire be responsible for extinguishing the flames has not escaped us.”
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