This week captured the heart of the current market debate: will it be a soft landing, or not, and with interest rates in the west having peaked, will central banks there signal a pivot to easing, or instead a continued pause?
The latest economic forecasts from the International Monetary Fund (IMF) pointed to a “soft landing” for the global economy, with decelerating inflation and modest growth, although the latter is dependent upon interest rate cuts that the former will allow.
However, this week also saw prospects of early rate cuts being dampened following the latest policy meetings of the US Federal Reserve and the Bank of England. The Fed’s messaging was no rate cuts just yet and certainly not at the time of their next meeting in March. The Fed appeared keen to lead and not be led by financial markets – their messaging aimed at getting ahead of the market in influencing expectations regarding the timing of rate cuts.
The Bank, meanwhile, was more hawkish in its communication and voting, with two of the nine-member Monetary Policy Committee (MPC) voting to hike rates. But in subsequent press interviews the Governor seemed to endorse the market’s thinking of the first rate cut in June.
The challenge in the UK is that monetary policy is already too tight. If the Bank doesn’t ease policy soon then it may be heading for a Pyrrhic victory over inflation, as the economy will suffer if policy is kept too tight, for too long.
In December, financial markets rallied strongly as they discounted aggressive rate cuts in 2024, starting soon and led by the US.
January, though, has seen a reality check as well as a heightened new concern. The reality check has been a dampening of those interest rate expectations.
Meanwhile, a cautious tone was promoted by the emergence of renewed geopolitical concerns. January saw a focus on disruption to sea routes in and around the Gulf, and while worries about disruption to supply chains may add to inflation concerns, this should not be exaggerated, but monitored. Yet the real underlying geopolitical concern was about what might happen post the US election regarding support for Ukraine – and whether one outcome might be less support, thus empowering Russia. In addition, the fear was what this might imply for NATO, its article 5 commitment and the potential need for increased future defence spending in Western Europe at a time when budgets are tight.
For now, the markets are not focussed on the latter, but it may be an issue that comes to the fore as the year progresses. Often, geopolitical worries can also lead to a risk premium being factored into energy prices. However, this is not happening currently. That in turn might reflect a sluggish pace of global demand. As one can see, there are many different factors overhanging the market outlook.
The Fed tries to get ahead of the curve
In December, Fed Chairman Powell’s press conference caught markets by surprise, and fed an immediate reassessment of the outlook for interest rates, with sizeable cuts being factored in. At his press conference this week, Powell was far more reserved. The way I interpreted this was that he was not trying to change the market’s expectation that rates would fall, but he did not want the market to drive the agenda and to effectively price in fully the timing of the first rate cut – thus leaving the Fed to be a follower. Instead, he wanted the Fed to lead expectations – and therefore get ahead of the curve. Accordingly, he dampened down expectations regarding a rate cut in March.
Powell reiterated that the Fed will be data dependent. Even though monetary policy acts with a long and variable lag, and policy changes take time to feed through, the tendency among central banks in the west, whether it be the Fed, ECB or Bank of England, is to react to the data.
When it comes to monetary policy, there is a need to differentiate between the west and emerging economies, as in the latter policy was prudent ahead of the rise in global inflation. For western central banks, policy has moved from previously being lagging to now being coincident – responding to latest economic data.
If they were forward looking one might argue that they should be cutting already. Our expectation has been that all three central banks will cut in the second quarter and that seems more likely after this week’s policy meetings.
The Fed has a dual mandate and may be waiting to see signs of a softer labour market. Also, at their next meeting in March it will reassess its approach to shrinking its balance sheet via quantitative tightening. This is logical as it makes no sense to engage in further QT at the same time as preparing to cut interest rates.
In contrast the Bank of England seems to bizarrely view QT as a purely technical and not a policy exercise.
When then of the BOE’s view on rates?
The Bank voted 6-3 this week to leave rates on hold at 5.25%. Two members voted to hike, which is far too hawkish. Unlike the Fed, the Bank does not have a dual mandate which raises the risk of a bias to keep policy too tight. One member voted to cut, which strikes me as the right approach. Inflation is decelerating and will hit the 2% target soon. Financial conditions are too tight. Growth is sluggish.
The market expects the first cut in June and rates down to 4.25% by year-end. That seems a sensible expectation given the Bank’s current stance.
In its comments the Bank noted, “Twelve-month CPI inflation fell to 4.0% in December 2023, below expectations in the November Report. This downside news has been broad-based, reflecting lower fuel, core goods and services price inflation. Although still elevated, wage growth has eased across a number of measures and is projected to decline further in coming quarters. CPI inflation is projected to fall temporarily to the 2% target in 2024 Q2 before increasing again in Q3 and Q4.”
We have long held the view that inflation would achieve its target in the second quarter of this year before trending higher. The BOE seems to have now come to that view, too.
What is the case for tightening? In my view it is a weak one, given the economic outlook. But inflation is expected to rise, albeit slightly, in the second half of the year. The Bank expects inflation to reach 2.75% by year-end, and to be 2.3% in two years and 1.9% in three years.
The Bank also raised its projection for growth. But its inflation and growth expectations are predicated on the market’s views on interest rates (falling to 3.25%) which are not in line with how the Bank is currently voting or thinking. If policy is kept tighter than implied by the market, growth and inflation will be lower.
IMF soft landing
The immediate focus – for markets and policy makers – is likely to be on core inflation. In this respect it is interesting to note that the IMF sees global inflation decelerating from 6.8% in 2023, to 5.8% this year and 4.4% next.
In my view, the two factors that were the triggers for the rise in inflation have been corrected, namely supply-side shocks and previously lax monetary policy. But the messaging this week from the Fed and the Bank reflected concern if inflation persists or if new supply shocks trigger higher inflation.
Disinflation appears the most likely outcome, as decelerating inflation allows interest rates to fall in western economies, and as rising real incomes contribute to modest growth. But monetary indicators suggest we may be heading for a hard landing and policy easing is needed. Thus, the downside risk should not be dismissed – although it is more of a concern in the UK and western Europe than in the US.
Also, it’s important to stress that the IMF’s projections for global growth are modest by pre-pandemic standards. An alternative way of looking at the IMF’s forecasts is that it’s bad but it could be worse.
The IMF sees the global economy growing 3.1% this year. That is above the 2.9% they were projecting for 2024 when they made their previous forecasts in October. This would be the same growth rate that the world economy achieved last year. Global growth of 3.2% is their forecast for next year.
Notably, 3.1% is a dismal rate of growth. It used to be consistent with parts of the world economy being in recession and is well below the 3.8% that was the global average between 2000 and 2019, before the onset of the pandemic.
Another aspect of the IMF’s economic outlook that attracted attention was their warning to the UK not to relax fiscal policy in the imminent March Budget. It made me think of watching referees in Premier League football and wishing that they would be consistent. For at the same time as the IMF was warning the UK, they were implicitly praising US fiscal policy as being synonymous with the US’s strong economic performance over the last year – which they attributed to “fiscal support” alongside strong consumer spending. So relaxing fiscal policy on a large scale in the US, where the budget deficit is high, was seen as good. But to even attempt a fraction of that in the UK would be bad.
Attention in the UK has also started to turn to fiscal policy in the approach to the early March Budget. As with last year’s Autumn Statement the focus is on how much fiscal space the Chancellor may have to ease policy through tax cuts. In December, public sector net debt excluding banks was £7.8 billion, and £8.4 billion lower than a year earlier. The trend is improving, helped by inflation boosting tax revenues. Despite this, the overall position is still poor. In December, public sector net debt was 97.7% of GDP and – excluding the Bank of England debt – was 88.7%.
Fiscal stabilisation is vital and with debt levels high already, it is the future relationship between interest rates and growth that becomes key.
In March much depends upon the forecasts from the Office for Budget Responsibility (OBR). Currently, the combination of a better trend on the public finances, plus decelerating inflation and the markets’ expectation of rates being lower than previously expected all improve the fiscal space, and the potential for some limited tax cuts.
In conclusion, the UK economy may receive a small fiscal boost in March and its first rate cut in this cycle in June, with more rate cuts to follow in the second half of the year.
Please note, the value of your investments can go down as well as up.