A screen shows the Fed’s interest rate announcement as a trader works on the floor of the New York Stock Exchange (NYSE) on November 2, 2022.
Brendan McDermid | Reuters
The US Federal Reserve, European Central Bank, Bank of England and Swiss National Bank all hiked interest rates by 50 basis points this week, as expected, but markets are refining their shifting tones.
Markets reacted negatively after the Fed raised interest rates by 50 basis points on Wednesday to a 15-year high. This marked a slowdown from the previous four sessions, in which the central bank implemented a 75 basis point hike.
However, Fed Chair Jerome Powell signaled that despite recent signs that inflation may have peaked, the fight to bring it back to manageable levels is far from over.
“There’s really an expectation that services inflation isn’t going to come down anytime soon, so we have to stay with that,” Powell said in Wednesday’s news briefing.
“We may need to raise rates higher to get where we want to be.”
On Thursday, the European Central Bank followed suit, also opting for a smaller rate hike, but indicated it would need to raise rates “significantly” more to tame inflation.
The Bank of England also implemented a half-point hike, adding that it would “react forcefully” if inflationary pressures start to look more sustained.
George Saravelos, head of FX research at Deutsche Bank, said major central banks had given markets a “clear message” that “financial conditions must remain tight”.
“We wrote in early 2022 that this year was all about one thing: rising real interest rates. Now that central banks have achieved this, the issue in 2023 is different: preventing the market from doing the opposite,” Saravelos said.
“Buying risky assets on the premise of weak inflation is a contradiction in terms: the associated loosening of financing conditions undermines the very weak inflation argument.”
In this context, Saravelos said, the explicit shift of focus by the ECB and the Fed from the consumer price index (CPI) to the labor market is noteworthy, as it implies that supply-side goods movements are insufficient to declare “mission accomplished”. “
“The overall message for 2023 seems clear: central banks will backtrack to riskier assets until the labor market starts to turn,” concluded Saravelos.
Optimized economic prospects
The hawkish message from the Fed and ECB surprised the market somewhat, although the policy decisions themselves were in line with expectations.
Berenberg on Friday revised its final rate forecasts to reflect developments over the past 48 hours and added an additional 25 basis point rate hike for the Fed in 2023, bringing the peak for the year to a range between 5% and 5.25% first three meetings of the year.
“We still believe that inflation falling to c3% and unemployment rising to well above 4.5% by the end of 2023 will eventually trigger a swing to a less hawkish stance, but for now the Fed clearly intends to turn higher go,” said Berenberg chief economist Holger Schmieding.
The bank also raised its forecast for the ECB, which is now set to hike rates at a steady pace to “restrictive levels” for more than one upcoming meeting. Berenberg added another 50 basis point move on March 16 to its existing 50 basis point expectation on Feb. 2. This increases the ECB’s main refinancing rate to 3.5%.
“Starting from such a high level, however, the ECB will likely have to cut interest rates again once inflation has fallen to just under 2% in 2024,” said Schmieding.
“We now expect two cuts of 25 basis points each in mid-2024 and leave our call for the ECB’s main refinancing rate at the end of 2024 unchanged at 3.0%.”
The Bank of England has been a little more dovish than the Fed and ECB and future decisions are likely to depend heavily on how the expected UK recession plays out. However, the Monetary Policy Committee has repeatedly expressed caution about the tightening of the labor market.
Berenberg expects another 25 basis point hike in February to take the policy rate to a peak of 3.75%, with a 50 basis point cut in the second half of 2023 and another 25 basis points by the end of 2024.
“But against the backdrop of upside surprises in recent economic data, the additional 25bp rate hikes by the Fed and BoE do not significantly change our economic outlook,” said Schmieding.
“We continue to expect the US economy to contract by 0.1% in 2023, followed by 1.2% growth in 2024, while the UK is likely to enter a recession with GDP falling by 1.1% in 2024 2023, followed by a 1.8% rebound in 2024.”
For the ECB, however, Berenberg sees that the additional 50 basis points expected from the ECB will have visible effects and will dampen growth most noticeably in late 2023 and early 2024.
“While we leave our forecast for real GDP next year unchanged at -0.3%, we are lowering our forecast for the pace of economic recovery in 2024 to 1.8% from 2.0%,” Schmieding said.
However, he noted that central banks’ forward guidance and shifts in tone throughout 2022 have not proven to be reliable guides for future policy action.
“We see the risks to our new forecasts for the Fed and BoE as balanced in both directions, but as the eurozone winter recession is likely to be deeper than ECB forecasts and as inflation is likely to fall significantly from March, we see a good chance that the final ECB rate hike in March 2023 will be 25 basis points instead of 50 basis points,” he said.