FILE PHOTO: Federal Reserve Chair Jerome Powell speaks in Washington, U.S., September 23, 2022. REUTERS/Kevin Lamarque/File Photo/File Photo
IT was a busy week for most central banks this time around as most of them met up for the last time in 2022, including the Federal Reserve (Fed), European Central Bank (ECB) and Bank of England (BoE).
On the Fed, the central bank voted unanimously to raise rates by 50 basis points (bps) to 4.25%-4.50%, in line with ours and market expectations.
The texts from the Fed reiterate the “ongoing increases” in the fed funds rate will be “appropriate”. Weeks prior the meeting, the Fed chair has said that the Fed is ready to reduce the pace of interest rate hike.
The Fed’s forecast update has the central projection for the fed funds rate to end 2023 at 5.1% and 4.1% for 2024, meaning the Fed is expecting higher interest rates during the next and the following year. Previously, they were 4.6% and 3.9%.
Meanwhile, the Fed is not willing to make a call on the scenario of inflation undershooting two consecutive times that have led us and the market to believe we are getting very close to the peak for interest rates, and rate cuts will soon be on the agenda.
Modest downturn
The Fed is looking at a modest downturn in activity in 2023. The unemployment rate would rise to 4.6% from the current level of 3.7%, with the economy continuing to expand at just 0.5% in 2023.
While the market may view inflation as being in its death throes, the Fed certainly does not.
For the Fed to relax, it will want to see substantial evidence that inflation is slowing, not just one or two months where core inflation has come in less than what the market was expecting.
We now expect another 50 bps hike in February 2023. But the Fed wants more evidence on the inflation environment. If there are more evidence of inflation easing, then a 25 bps hike is expected instead.
Our view remains that the Fed will pause in the second quarter of 2023 (2Q23) and thereafter, institute its first rate cut in the second half of 2023 (2H23).
We believe the downturn will be more painful than the Fed is currently anticipating in 2023.
The recessionary forces will dampen price pressures which are heavily weighted to shelter and vehicles.
Meaning that they will facilitate a far faster drop in inflation readings, on top of the easing energy prices. We are looking at 100 bps cut in 2H23 for now.
Across the Atlantic, the ECB also followed Fed’s footstep by making a smaller rate hike of 50 bps, pushing the main refinancing rate to 2.50%.
The slower pace of rate hike could be attributed to some signs of price pressures easing and a recession looming.
Hawkish tone
We found the following tone from the ECB in the latest policy meeting to be hawkish.
The central bank cited “interest rates will still have to rise significantly at a steady pace to reach levels that are sufficiently restrictive to ensure a timely return of inflation to the 2% medium-term target”.
And the ECB further said that keeping interest rates at restrictive levels will over time reduce inflation by dampening demand and will also guard against the risk of a persistent upward shift.
Meanwhile, the ECB expects only a short and shallow recession. The central bank forecast eurozone growth to come in at 0.5% in 2023 and 1.9% in 2024.
We feel it is far more optimistic than our own growth forecast of minus 0.2% and 1.5% in 2023 and 2024, respectively. The situation surrounding gas shortage and Russia-Ukraine war are far from over.
And the ECB is also expecting inflation to come down to 3.4% in 2024 and 2.3% in 2025. The 2024 number was revised upwards significantly. This justifies for more rate hikes in the future.
However, we still feel there is very little the ECB can do to bring down inflation.
What we believe is that the central bank may be able to address inflation expectations.
Following the hawkish tone with smaller rate hike, we are of the view that the ECB will use the interest rates to address inflation.
We expect another 50 bps hike in 1H23 to bring the policy rate to settle at 3%. Balance sheet reduction will stay at the backseat.
And our concern remains that the ECB could push the eurozone economy further into recession with every new rate hike. We remain sceptical on their relatively optimistic growth outlook.
In the UK, the BoE also raised rates by 50 bps in the final meeting of the year, pushing the base rate to 3.50%.
This follows the Fed’s and ECB’s footstep of a smaller rate hike without pushing the UK’s economy into a deeper slowdown.
Recent inflation reading has cooled from 11.1% in October 2022 to 10.7% in November 2022.
Still, the overall inflation is high and way off from the desired level. Besides, domestic wage and price pressure remain elevated.
Recession likely
The economy is expected to be in a recession amid weaker household consumption and lower investment activities among businesses. This would drag down inflation from mid-2023.
For 2022, we expect the UK’s gross domestic product to grow by 4.4%, and to decline by minus 1.5% in 2023 and 0.5% in 2024.
On the policy rate outlook, with inflation still elevated, we expect the BoE will continue raising the interest rate in 2023.
And since the BoE did mention that it will respond “forcefully” if inflationary pressure remains persistent, we are looking at another 50 bps rate hike in the upcoming meeting in February 2023, pushing the base rate to 4%.
Overall, inflation numbers for the past couple of months were showing some signs of cooling down, taking off some pressure on central banks from taking aggressive measures.
But the fight against inflation is far from over, as inflation is still far off from the desired target.
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