Central banks face tough journey to ‘Goldilocks’ policy setting
Goldilocks found the perfect bowl of porridge through trial and error. The US Federal Reserve, Bank of England and the rest of the central banking elite are following a similar rationale right now.
They are grasping for that “just-right” policy setting which allows an economy to reach its full potential without knowing what that setting is – the so-called terminal interest rate.
They have recognised the old monetary order was clearly out of whack. Now, they are acting.
Get it right, and central banks will be praised for effectively taming the worst bout of global inflation in recent memory.
Get it wrong, and they will be partially blamed for dealing unnecessary damage to their respective economies.
At a time when monetary authorities are being scrutinised for letting inflation run out of control in the first place, avoiding policy mishaps will be crucial to protecting their political independence and credibility in the long-run.
UK
Britain is probably the most at risk of tipping into a recession out of the world’s richest economies.
The country is suffering from both an extremely tight jobs market, seen in the US, and is exposed to high energy prices, similar to Europe.
A shallower workforce is hamstringing firms’ ability to capitalise on high demand by growing. That same dynamic is putting upward pressure on wages.
“There are still around 1.15m fewer people in the labour force than on pre-pandemic trends,” according to the Institute for Employment Studies.
Add into the mix having to pay more for goods stuck in supply chain bottlenecks, and you generate a 40-year high inflation rate of nine per cent, higher than America and the eurozone.
Rates have already climbed to a 13-year high of 1.25 per cent in response, but they are low by historical standards. The Bank rejected a 50 basis point rise last week despite lifting its expected inflation peak to just over 11 per cent.
One of the UK’s biggest headaches is a lack of economic diversity. Consumer spending accounts for around two thirds of output. Without the services sector, the country’s trade balance would be shocking.
The former is set to come under pressure from the cost of living squeeze dealing a record hit to living standards and, in turn, sparking a spending slowdown.
The latter is suffering from uncertainty over the future trading relationship with Europe. However, a weaker pound may boost international sales. It will also stoke inflation by making it more expensive to buy foreign products.
The Organisation for Economic Co-operation and Development (OECD) thinks the economy will flatline next year. Only Russia will post weaker growth than the UK in the G20.
But, chancellor Rishi Sunak’s £15bn fiscal boost to cushion the cost of living blow has reduced the risk of an economic reversal.
That package has given the Bank more room to bear down on inflation. Higher rates will undoubtedly curb spending and weigh on confidence, but the ripple effects will be less severe as the government steps in.
Leaving policy accommodative risks keeping inflation higher for longer.
With wage growth failing to keep up with price rises, that could be more damaging for the economy in the long-run than delivering a short, steep rate rise cycle.
US
The US Federal Reserve is taking the lead among the central banking community in dialling up the fight against inflation.
Last week, chair Jerome Powell and co signed off the first 75 basis point rise since 1994 after it was spooked by the latest inflation figures – a four decade high of 8.6 per cent – smashing Wall Street’s expectations.
Core inflation also surprised to the upside, indicating price pressures are spreading across markets and are stickier than first thought.
Yields on US government debt have surged as traders price in the higher rate environment. While this will weaken the pound and the euro, it will help the US by drawing in foreign investment.
But, the Fed’s hikes will weigh on American companies that have a strong international presence, such as Apple and Microsoft, by making it more expensive to buy their products abroad due to dollar appreciation.
Wall Street’s S&P 500 and Nasdaq indexes have each tumbled into a bear market. Other asset prices have cooled in response to the Fed’s tightening. The housing market looks more fragile.
That market adjustment is making Americans feel worse off, signalled by the Michigan University consumer confidence index dropping to its lowest level ever.
The country’s jobs market is extremely tight, but wages are trailing inflation. However, strong demand for workers will partially shield incomes.
The OECD thinks the US will squeeze out 2.5 per cent and 1.2 per cent of growth this year and next.
But, those conclusions were drawn before the Fed’s 75 basis point rate rise bazooka last week. With rates headed toward four per cent, the risk of a recession has significantly increased.
Eurozone
Members of the European Central Bank (ECB) scrambled last week to cobble together a plan to tame volatility in debt markets. The move recalled memories of the 2012 and 2014 debt crises.
The emergency meeting illustrates how managing different nations that have varying degrees of economic strength often poses a roadblock to the ECB’s policy aims.
Markets responded to president Christine Lagarde earlier this month confirming a first European rate rise in over a decade and the end of bond buying in July by ditching Italian government debt, sending yields higher.
This sell-off intensified eurozone market fragmentation – when spreads between respective eurozone countries’ debt widen – highlighting that recession risks diverge across the Continent.
The likes of Germany and France can swallow higher rates. Italy and Spain will struggle without ongoing ECB support, partly the reason why Lagarde and co said last week they are creating a tool to allow them to buy weaker countries’ debt.
If European rate setters do not get on top of high inflation – running at 8.1 per cent, the highest since the creation of the euro in 1999 – it risks being embedded in the bloc over the long-run.
The area will eventually have to wean itself off Russian energy, a move which seems more likely than not to keep inflation elevated for some time. Either lower supplies of or higher prices for oil and gas will curb output in Germany, the bloc’s economic engine, hurting overall eurozone growth.
Eurozone growth will hit 2.6 per cent this year and 1.6 per cent next, according to the OECD.
Japan
Japan’s central bank last week bucked the global tightening trend and left policy accommodative. It is now the only top central bank to leave rates unchanged.
It reaffirmed its short-term rate target of minus 0.1 per cent and left its 0.25 per cent 10-year government debt cap unchanged. It also promised to keep buying unlimited volumes of bonds.
Inflationary pressures are seeping into Asia’s second-largest economy. Prices are 2.1 per cent higher than they were a year ago, the first time inflation has topped the Bank of Japan’s two per cent target for seven years.
The BoJ has been trying to stem the dampening effects of Japan’s ageing population on the economy for decades by attempting to stimulate demand through low rates.
Those efforts have had little impact. Inflation has actually fallen into negative territory.
Commitment to accommodative policy has tamed investors’ expectations for rate hikes. This – alongside the Fed accelerating its rate rise cycle – has led the yen, Japan’s currency, to plunge against the dollar.
The yen’s depreciation will make it more expensive for Japan to import goods, but may boost Japan’s tourism sector by making holidays cheaper.
The BoJ’s stimulative policy should shield demand, decreasing recession risks. The OECD reckons Japan’s economy will grow around 1.8 per cent this year and next.
Switzerland
Perhaps the best sign of the changing tide of central banks’ policy stance came last week from Switzerland.
Its central bank unexpectedly lifted rates 50 basis points to minus 0.25 per cent. Most people were anticipating the Swiss National Bank (SNB) to stick to the status quo.
The shock move dialled up analysts expectations.
“Given the SNB’s hawkish surprise… we now look for three further 50 basis point hikes in September, December and March next year, followed by one further 25 basis point hike in June of next year for a terminal rate of 1.50 per cent,” Goldman Sachs said.
The SNB forecasts inflation, currently running at a 14-year high, will still be above target in the first three months of 2025, raising the likelihood of further rate rises.
“While the SNB’s forecast of 2.5 per cent GDP growth this year remained unchanged, the monetary policy assessment flagged significant downside risks, such as a further rises in energy prices, a worsening in supply chain health, and a resurgence of covid,” Goldman added.
Other notable policy shifts have come from Australia and New Zealand’s central banks, each of which have raised rates 50 basis points recently.
While the world is unlikely leaning back into an era where double-digit borrowing costs are commonplace, it is clear rates are moving upwards and away from the historic lows where they have been for over a decade since the financial crisis.