Our graph of the week shows that financial markets continue to price a much higher ECB policy rate a year from now than they did before the 15 December meeting of the Governing Council. In contrast, faced with disappointing economic data, lower inflation and somewhat dovish policymaker comments, market expectations for US central bank policy have receded. Do not be fooled: the tightening cycle is not over yet, not in the eurozone and not in the US.
In December, after the ECB’s most recent monetary policy meeting, President Christine Lagarde sent a hawkish message, insisting that compared to the Fed, the ECB had ‘more ground to cover’ and ‘longer to go’. Markets reacted by pricing in a higher level for forward rates (see red circle on the graph highlighting the sharp rise in expectations).
Speaking at Davos on 19 January, Ms Lagarde dashed hopes that the ECB’s tightening cycle was ending, suggesting investors would be well advised to ‘revise their position’ for a lower peak for ECB rates because the ECB was determined to ‘stay the course’.
The rationale for this determination became clear later that day with the publication of the minutes of the ECB’s December meeting. They showed that a large number of governing council members would have preferred to raise rates by 75bp, but agreed to a lower 50bp increase under the explicit assumption that rates would continue to rise at that pace.
The forward guidance by Ms Lagarde of “another 50 basis points rate hike at our next meeting, and possibly at the one after that, and possibly thereafter” reflects the position of the governing council. The bar for a rapid slowdown in the pace of rate rises looks high indeed.
US core inflation falling; not in the eurozone
There is a significant difference between core inflation in the US compared to the eurozone. Core inflation, which excludes changes in the cost of energy and food, is falling in the US, whereas in the eurozone it has been rising, to 5.2% in December up from 5% in November.
Members of the ECB’s governing council have warned of their concern that elevated inflation could become entrenched via second-round effects. Ms Lagarde pointed out this week that the eurozone’s resilient jobs market could lead to higher wages.
In contrast, Lael Brainard, the Fed’s vice-chair, signalled in a recent speech that US wages “do not appear to be driving inflation in a 1970s-style wage-price spiral.” She also referred to signs of slacker labour demand and a weakening manufacturing sector as evidence that the US economy is cooling and inflation is on a downward trajectory.
Here’s what we expect
At the meeting of FOMC policymakers on 31 January and 1 February, we expect them to raise the US federal funds rate range by 25bp from 4.25-4.5% to 4.5-4.75%.
- We expect the FOMC to continue to guide toward a 5.25% terminal rate in the first quarter of 2023
- The Fed’s message is likely to be hawkish, acknowledging a weakening US economy while simultaneously pledging to ‘stay the course’ and maintain a restrictive policy until inflation is convincingly on its way back to target
- The meeting statement may downgrade the assessment of current economic activity and signal that while further rate rises are in store, the Fed will be relatively more cautious than when it was in catch-up mode last year
- Key will be, in our view, what Chair Jerome Powell says in the press conference about the US labour market. Will he be more amenable to the idea of a soft landing than in recent meetings? We’d expect he will continue to emphasise that inflation remains the Fed’s top priority.
We expect the fed funds rate to peak at 5.00-5.25% in the first quarter of 2023.
The ECB’s governing council meets on 2 February. We expect it to follow through on its guidance and raise the deposit rate by 50bp from 2.00% currently and again in March.
With hard economic data for the fourth quarter of 2023 having come in better than expected and with lower energy prices, the council may see a more positive growth outlook over the short term compared with its December projections. In the absence of updated projections, the ECB will likely stick to its December view of a strong rebound in the second half of 2023 and in 2024.
We expect further increases in the deposit rate by 25bp each in May and June leading to a terminal policy rate of 3.50%. The market is currently pricing a slightly lower terminal rate, at 3.34%.
Why will the ECB keep hiking despite better data?
In our view, the ECB is in ‘risk management’ mode: it aims to avoid, at all costs, the worst inflation outcomes. A speech by Isabel Schnabel, member of the ECB’s executive board, at Jackson Hole in August 2022, outlines the approach:
“There are two broad paths central banks can take to deal with current high inflation: one is a path of caution, in line with the view that monetary policy is the wrong medicine to deal with supply shocks. The other path is one of determination. On this path, monetary policy responds more forcefully to the current bout of inflation, even at the risk of lower growth and higher unemployment. This is the “robust control” approach to monetary policy that minimises the risks of very bad economic outcomes in the future. Three broad observations speak in favour of central banks choosing the latter path: the uncertainty about the persistence of inflation, the threats to central bank credibility and the potential costs of acting too late.”
The good news is that the ECB will stand ready to ease monetary policy as soon as there is evidence that the risk of ‘very bad outcomes’ has faded. We do not expect such news in the first half of 2023.
The ECB expects core inflation to start falling in the third quarter of 2023. Until then, barring major downward surprises to core inflation, the central bank is likely to judge any change in their overall policy stance as premature.