A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK.
After a run of large interest rate rises over the summer, central banks seem likely to ease the pace of monetary tightening. We’re not there yet, but much of the heavy lifting in terms of rate rises in this economic cycle has happened.
In early May, interest rates in the US and UK stood at 0.5% and in the euro area at -0.5%. Monetary policy looked out of line with inflation which was running around the 8.0% mark.
The ensuing six months have seen the most rapid tightening of western monetary policy in more than 30 years. Since the 1990s central banks have tightened policy slowly, usually raising rates by 25bp or, less frequently, 50bp. It is a measure of the scale of the inflationary challenge today that the Federal Reserve, which last raised interest rates by 75bp in 1994, has implemented four consecutive 75bp rate hikes since May. US rates have risen from 0.25% to 4.0% in nine months.
It’s the same story of catch up elsewhere. The European Central Bank (ECB), which had only ever raised rates in 25bp or 50bp increments, raised rates by 75bp in September and then again in October. The UK was the first of the major central banks to raise rates last December. UK rates have risen from 0.25% to 3.0%, with the latest increase being 75bp. The Canadian and Australian central banks have gone faster, raising rates in 75bp and 100bp increments.
Outside Japan, western interest rates are at the highest level in 15 years. Tighter policy is slowing growth and inflation looks at, or close to, a peak. Monetary policy no longer looks desperately behind the curve.
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In the US supply and demand seem to be moving closer to balance. Inventories have recovered from the rock bottom levels reached last year. The Purchasing Managers’ measure of unfilled orders hit record highs last year but is back to normal levels. Supply chain problems have moderated. The price of most commodities – oil, gas, metals, agricultural products and semiconductors – have fallen from their peaks earlier this year. With the consumer goods boom petering out and commodity prices easing US goods inflation has fallen away sharply. In October, consumer price inflation came in below market expectations, fuelling hopes that US inflation is at or near a peak.
The minutes of the Fed’s November meeting released last week suggest a change in mood among US policymakers. A “substantial majority” of the rate-setting committee now favours slowing the pace of US rate rises.
Financial markets expect the campaign of rate rises to continue, but central banks to move in smaller increments with the Fed, Bank of England and Bank of Canada raising rates by 50bp in December and Australia’s central bank hiking by 0.25%.
The ECB is the one major central bank that still seems to be in catch-up mode. Euro area inflation stands at 10.6%, a bit below the UK and higher than in the US, yet euro area rates of 1.5% are less than half levels in the US or UK. Markets expect the ECB to be the outlier among central banks next month, raising rates by 75bp at their meeting on 15 December.
Next year, financial markets see US rates peaking at 5.0%, UK rates at 4.75% and euro area rates at 3.0%. (Market expectations for the peak in UK rates surged to over 6.0% following the mini-budget in September but with the withdrawal of the package and a tightening of fiscal policy have since fallen back sharply.)
Markets think that US rates now stand at 80% of their expected peak (4.0% vs 5.0%), UK rates are at 63% of their peak and euro area rates are at 50% of the expected peak.
Over the last 50 years, the US and UK economies generally enter recessions with interest rates at or near their peak. The lion’s share of rate rises precedes the downturn. With the onset of recession, contracting activity creates spare capacity and inflation starts to ease. In the past, central banks have therefore tended to lower rates during the recession. This cycle may prove to be different but, were it to conform to this template, central banks would reduce rates later next year.
Unfortunately, inflation is not currently at levels consistent with an easing of policy. Some drivers of headline inflation have moderated, but that respite could be short-lived. Commodity prices are volatile and supply bottlenecks remain. Most importantly, underlying price and wage pressures are strong.
Central banks need to engineer weaker growth to create spare capacity in the economy. That means a weaker labour market and higher unemployment. Despite the recent campaign of central bank rate hikes, unemployment rates in the US, UK and the euro area are running close to 50-year lows.
Slowing activity will weaken labour markets over the coming months. My hunch is that interest rate reductions will follow, though probably not until the second half of next year.
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