Are central banks transforming from hawks into doves?
If investors were hoping for a turnaround in fortunes, they hardly could have asked for a better start to the year. February began just where January left off: dominated by central bank action, inflation, and despondency over the UK economy. Meanwhile, stock and bond markets stayed buoyant. The monthly US jobs report could have upended the week, but after a brief market wobble, the FTSE 100 ended the week by hitting an all-time high.
Friday’s US Labor Department’s report showed the US economy added an almost unbelievable 517,000 new jobs in January, while the previous month’s data was also revised up. All of a sudden, the big risk to investment markets this year is not so much a global recession, but the robust jobs market. The US employment report was probably not known to the Federal Open Market Committee (FOMC) when its members slowed the pace of rate rises earlier in the week. Last Wednesday, the US Federal Reserve (Fed) raised the Fed funds rate by 0.25% to a midpoint of 4.625%. On Thursday, the Bank of England (BoE) raised the base rate to 4.0%, and the European Central Bank (ECB) effectively raised its short-term rate by 1.0% to 3.0% (0.5% now and another 0.5% in March). However, you could be forgiven for thinking they had all announced rate cuts, given the very positive reactions of both bond and equity markets.
Given that an end to the current tightening was signalled quite strongly by all three central banks, investors have an increasing belief that monetary policy-driven constraints on profitability are coming to end in the nearer-term. In fact, investors not only expect an imminent peak in US, UK and European interest rates, but think they will start actively loosening monetary policy before the end of the year. With financial conditions loosening, the global economy may already have started its next growth cycle. As ever, though, we suspect one shouldn’t get carried away by waves of positivity. Interest costs are still higher than before, and still have a bit further to go. There are good reasons to think that economic growth may rebound from here, but it feels less plausible that profit growth will be exceptional.
How long is the lag – or why is that lag suddenly shrinking?
We had two reports on the UK economy last week, one from the International Monetary Fund (IMF) and the other from the BoE accompanying its rate decision. The IMF report was depressing reading but was very much in line with the gloomy BoE report published last Autumn, although as is often the case, the IMF report felt out of date. In contrast, at least for the nearer-term outlook, the improving inflation picture allowed the BoE to revise its growth projections up Autumn’s report.
Inflation optimism is the main reason for the market rally seen this year, and reflects a ‘job well done’ attitude in markets: inflation is or will soon be under control, after which things can get back to normal. But to judge how accurate this view is, we need to know how inflation will develop over the next year and how it will be impacted by monetary policy. Conventional economic wisdom tells us monetary policy has ‘long and variable lags’. In other words, rate hikes or cuts take a long time to filter through to the real economy.
One theory suggests that in the past, interest rates took a while to affect the real economy because the primary mode of transmission was bank lending – an inherently slow-moving process. But over the last decade in particular, such lending has had a much smaller role. Highly-traded corporate bond markets are much more important for businesses, while asset markets are much more important for households (as stock ownership is much higher). These markets are now more sensitive to interest rates and investor sentiment. Moreover, capital markets have become more aligned to monetary policy over the last couple of decades, in part because central bankers are eager to communicate policy far in advance and remove sudden shocks, and in part because forecasting interest rates has become one of the biggest components of any investment portfolio. This results in a feedback loop where investors look for any clues in central bank announcements, and those announcements are tailored for a nervous investor audience.
Shorter lags can be both good and bad. Optimists will say that loosening monetary policy could boost demand before the year is up. If the lag really is long, one could not expect any short-term recovery. If it is short, there is every chance the global economy will improve substantially in the second half of this year. Combine this with the strong growth boost we expect to see from China’s post-COVID re-opening, and we could be in for a decent ride.
The pessimistic view is that central banks might not loosen after all. The current expectation – backed up by comments from its members – is that the Fed now wants to wait-and-see how inflation plays out rather than committing to further tightening. But markets also expect inflation to fall to the Fed’s 2.0% target, and for the US economy to avoid a deep recession. If the policy lag is shorter than expected, those things are unlikely to all be true at once.
Ultimately, the question policymakers have to grapple with is how much growth can be allowed before it becomes inflationary. The structural evidence we have seen post-pandemic – from labour markets and increased regionalisation of global trade – suggests that bar is low. Moreover, if the lag between interest rates and inflation is shorter than expected, central banks will have more incentive to tighten in the short term. Monetary policy transmission is highly complex, but we should not assume that means the job is already done