Reflection time for central banks

In the face of sticky inflation, central banks launched the most aggressive monetary policy tightening cycle in decades. Following a decade where central bankers struggled to raise rates at all, it shows a radical shift. Crucially, history shows that the full force of policy tightening takes some time to feed through. It therefore makes sense central banks want to see the effects of their so-called medicine.

It has been a long journey for the Fed and BoE to get to this point. However, the journey and the future for both are very different. 

The Fed previously paused, or skipped, in June but used that opportunity to telegraph an anticipated rate hike again in July. US data remained strong over the summer, leading the Fed to raise rates to 5.5%. Most expected the Fed to hold rates again this week, although investors keenly dissected it for further clues on future policy. This included whether the meeting would mark another ‘skip’ and how long the Fed intended to keep rates elevated. The Summary of Economic Projections (SEP), showed a slight majority pencilling in further rate increases later this year, but more meaningful is the expected future path of interest rates. Fed members now expect much fewer rate cuts next year, implying policy rates remaining above 5% throughout 2024. This provided the clearest signal yet that rates will stay higher for longer, and was supported by downward revisions to the unemployment rate. Furthermore, growth was revised upward while inflation projections moved a touch lower. In the press conference, Chair Powell downplayed these forecasts and emphasised data dependency. 

We agree it is important to remain slightly sceptical of the economic forecasts - lower inflation and lower unemployment projections do not typically happen simultaneously. 

It was seen as a “hawkish hold” as investors digested a higher hurdle for the Fed to consider cutting rates in the future but also little conviction in the need to raise rates further.      

Last week, most investors expected the BoE to deliver a further 0.25% increase. However, lower than expected inflation data earlier this week swayed them off course. Even though headline CPI only fell a touch from 6.8% to 6.7% year-over-year (YoY), it was expected to rise due to higher fuel costs. More importantly, core price pressures eased more meaningfully to 6.2% from 6.9% from the previous year. Earlier in the year, sharp increases in core price pressure led the BoE to ramp up its hiking cycle with a 0.5% increase in June. Given that strong reaction, it is not surprising to see them hold rates since price pressures experienced such sharp declines. While wage growth remains too high, the BoE is also cognisant that economic activity has weakened as previous increases are filtering through the economy. It was a tightly contested decision, with a 5 to 4 split on holding rates, indicating lingering concerns on future inflation. The message surrounding the decision appears to emulate the “Table Mountain” approach (as previously discussed in Inflation and Interest rates: a rocky expedition) and most likely marks the peak of BoE rate hikes. 

Central banks have travelled a long way to get to this point. While the economic resilience has surprised them so far, interest rates are now at a point where they believe will exert enough downward pressure on the economy to cool inflation.  As such, we now appear to be moving towards a more reflective, rather than reactionary time, for monetary policy.