This week saw both the US Federal Reserve and the Bank of England leave interest rates on hold. While this may suggest that policy rates have peaked, it is not yet certain. Both central banks still retain a bias to tighten.
The Fed’s decision to hold the funds rate at 5.25% to 5.5% was expected and made sense. The Fed made this clear in their communication that they remain vigilant.
While headline inflation continues to decelerate, the recent strong third-quarter US growth of a 4.9% annualised rate shows the economy remains resilient. In all likelihood, the Fed will not hike policy rates further and this has already set the tone for financial markets, which are looking for confirmation that this prolonged period of policy tightening has run its course.
Two years ago, most western central banks like the Fed and the Bank were clearly behind the curve. They had missed the pick-up in inflation. Policy was too loose.
They were not leading the markets but reacting to them. Then they had to play catch-up. The Fed’s Chair, Jerome Powell, did this well, through effective communication, to reposition himself relatively quickly. The last thing central banks would want now is to return to the previous position where they were seen as being behind the curve, having to react to the lead of the markets, as opposed to leading the markets.
But that is where they might soon be, if the markets conclude that monetary policy has gone from too loose to too tight, that inflation has peaked and is decelerating, and that economic growth may weaken.
In that context, markets will conclude that rates are not on pause, but have peaked and that it will only be a matter of time before the Fed and other central banks start to pivot towards rate cuts.
But even if this outlook materialises, the extent to which rates may fall will be limited. It fits with our thinking that markets will move from a focus on inflation to one on growth.
The Bank’s stance
Like the Fed, the Bank’s decision to leave rates unchanged at 5.25% was expected, as too was the divergence in voting. The nine-person Monetary Policy Committee (MPC) voted 6-3, with three of its four external members voting for a 0.25% hike, while the fourth plus the five Bank officials voted to keep rates on hold.
In my view, there are three aspects of the monetary policy stance now that warrant focus for investors and the financial markets: one, is the scale of tightening to date and that this has yet to feed through fully; two, is the Bank and the MPC’s judgement call about the economy that underpins their rate decision and whether this is appropriate; and three, and usually overlooked in much of the analysis, is whether the Bank is right to view quantitative tightening (QT) as a technical exercise. All are interlinked.
Tightening so far
We have seen significant monetary policy tightening in the UK, via both higher policy rates and a shrinking of the Bank’s bloated balance sheet. Policy rates have risen from 0.1% to 5.25%.
The latest weekly report from the Bank of England shows that the Asset Purchase Facility has fallen from its peak of £894.9 billion at the start of March 2022, to £804.1 billion in the week to October 16th 2023, and to £757.9 billion in the week to October 23rd. As we have noted, even when policy rates have peaked the Bank has indicated that it will continue to tighten, via quantitative tightening (QT), and thus shrink its balance sheet further.
In my view, the scale of tightening to date is sufficient already, and it will take time to fully feed through. This tightening is already slowing the economy.
Although the UK economy has shown resilience in recent years, it is sluggish, and while our expectation is that it will avoid recession, immediate growth looks weak with the balance of economic risks to the downside. This was also reflected in the Bank’s latest economic forecast, where it expects a weak growth outlook. Its growth forecasts for the final quarter of each year were 0.6% for this year; 0.0% in 2024, 0.4% in 2025 and 1.1% in 2026. Add in that inflation is decelerating and this would suggest that further policy tightening is not needed.
While the Bank and the market’s focus is on policy rates, more attention should be paid to the scale of QT. This rarely figures in the policy debate and it should. Just as the scale of Quantitative Easing contributed to inflation, too much QT, alongside high policy rates and a tight fiscal stance, threatens recession.
Part of the challenge is that the Bank portrays QT as just a technical exercise. While the execution of the policy may be technical its impact reflects significant policy tightening. Given the balance of economic risks, I think QT should be paused.
The Bank’s messaging
The Bank’s messaging that accompanied its rate decision was in line with expectations, too. The message from the Governor implied a bias to tighten and that they were waiting to see if the data will justify another hike. Yet, with the economy sluggish and inflation decelerating, instead of the issue being on whether rates rise further, in all likelihood the markets’ focus may be on when will policy and rates need to pivot towards easing.
Perhaps with that in mind, the Bank emphasised that it wants policy to be restrictive for “an extended period of time”. Given that the markets were not expecting a cut until later next year, the fact that the Bank added this comment suggests it felt it had to stress its message – although at the press conference, the Governor seemed, strangely, to downplay that they were trying to guide market rate expectations. Surely influencing the market’s thinking is part of their policy approach.
Also, while they view rates as being restrictive, at the press conference the Governor and Deputy Governor Broadbent said that they did not have a firm view about how restrictive policy was and where the balance is and thus where rates should settle – although clearly is lower than where they are now.
While this elusiveness over where rates should settle may be understandable it would be a concern if it persisted. Surely, we cannot expect the Bank to believe that r-star (the neutral interest rate in real terms, after allowing for inflation) is very low and close to zero, as it previously believed pre-crisis.
If so that would imply that after their current restrictive policy – that points to very weak growth, and possible recession – it will then lurch again to a cheap money policy, reigniting the same problems as before, such as asset price inflation, among others.
Inflation
On inflation, the Bank’s messaging was that such a restrictive monetary policy is working to reduce inflation. That is correct, and although the Bank has never acknowledged that its monetary policy stance previously (when it was too loose) contributed to inflation, the reality is that it did. Thus, its tightening, alongside the easing of supply-side pressures has allowed inflation to fall.
The Bank expects inflation to return to its target. The reality, though, is that it always says that. It is certainly likely to be right in its view of inflation over the next year when it looks set to decelerate significantly. The Bank is forecasting an imminent fall in inflation from its current 6.7% to below 5% in soon-to-be-released data for October. While that will be driven by energy prices, disinflationary pressures are then expected to become more broad-based.
The Bank forecasts consumer price inflation (CPI) inflation of 4.75% in Q4, 4.5% in Q1 next year and 3.75% in Q2. The collapse in monetary growth merited no attention, but while that should be viewed as strange it is consistent with the Bank’s previous approach. Further, while wages did not cause this inflation spike, they continue to attract much policy attention with the Bank analysing second-round inflation effects as wage growth continues to outstrip inflation.
In context
In some respects, the Bank’s split vote reflects that the current policy on rates is a judgement call, depending upon one’s read of the economy. The Bank needs to get the balance right and avoid over-tightening.
In contrast to the current judgement call, for much of 2020 to 2022 the Bank’s policy was clearly mistaken. It clearly made a huge mistake, not just in terms of how it misread the inflation outlook, but also how its policy actions failed to reflect the risks that lay ahead.
We were early to identify the inflation problem, saying that inflation would persist, and not pass through as quickly as the Bank expected, although we also thought the rise in inflation would be permanent. This read has been borne out by events.
Also, at the start of last year, in the Times annual survey of economists, we were one of only two respondents to say the peak in inflation would be above 7%.
That pessimism was justified. Early this year, writing a column in the FT I stated that policy rates would settle at a high level and stay higher for longer; this is a view that has since become the accepted norm and indeed was part of the Bank’s messaging at this latest meeting. And we have long held the view that inflation would settle in the future at a higher level, possibly 3% or so, as opposed to its 2% pre-crisis. That is still our read.
What lies ahead for policy rates? Whereas rates were too low for too long, I think they have already risen too far. I don’t think they should or will rise further, ending this year at 5.25%. But it would also not be a surprise if rates were to be cut in the second half of next year to 4.75%.
The MPC’s judgement call on rates reflects its read of the effectiveness of policy tightening to date as well as the economic outlook. Thus, it is important to understand what is driving its policy thinking and its cautious stance.
Although based on its view that inflation will decelerate to the 2% target and its view of a sluggish economic outlook (where the labour market is already easing) one would have to say that rates have peaked and the next move is likely to be down – albeit not for some time.
A prolonged pause, not a pivot to easing might be the implication. But as we move through next year, if the economy weakens then policy easing may be necessary, although the exact mix of that between fiscal and monetary policy needs to be determined.
