Guidance from the central banks

by Sean Tweedie | August 3, 2023

Central bank
July saw three G10 countries hold central bank meetings. The message from all three highlighted their critical dependence on data in their monetary policy decision. We look at the outcome of two of these meetings.

US Federal Reserve

The Federal Reserve raised interest rates by 25 bps bringing the target range for the funds rate up to 5.25%-5.50%, in line with expectations, the highest level in 22 years. Although the market reaction was initially muted, the dollar sold off following the press conference in what the market considered a dovish hike. A positive take-away that the Federal Reserve highlighted was that inflation is coming down. See figure 1.

figure 1

The year-on-year change in core PCE inflation, the Federal Reserve’s preferred inflation measure, has declined from a peak of 5.4% in February 2022 to 4.1% in June 2023. The Federal Reserve expects core PCE inflation to ease to 3.9% by the end of 2023 and 2.6% by the end of 2024. During his press conference, Chair Jerome Powell said that the Federal Reserve would cut rates “long before” inflation has returned to its 2% target due to the lagged effect that changes in monetary policy has on inflation dynamics.

Despite positive developments on the inflation front, Jerome Powell expressed some concern that tight labor markets and strong real economic activity could halt inflation’s decline before it returns to target. He specifically noted that, historically, at least some degree of labor market pain is required to return inflation to target. So far, the labor market has experienced far less pain than the Federal Reserve anticipated. BCA Research has calculated that, depending on trends in labor force participation, monthly nonfarm payroll growth will have to average between -37k and +87k for the next six months for the unemployment rate to hit the Fed’s 4.1% end-of-year forecast.

The policy implication of falling inflation and better-than-expected employment growth is that the Federal Reserve will likely keep interest rates on hold between now and the end of the year. It will also be slow to embrace rate cuts in 2024 until the labor market shows signs of cracking. It is important to remember the lagged effect of monetary policy changes and so it is likely that the full extent of past rate hikes has yet to be transmitted to the US economy.

European Central Bank

The ECB delivered a 25-basis point rate increase on Thursday, raising the policy rate to its 2001 record high of 3.75% and marking its ninth consecutive rate increase.

Governor Christine Lagarde, during the press conference, stressed the data dependency of the European Central Bank in their decision on whether to hike interest rates again in September. Lagarde also offered no forward guidance. She once again stressed that the interest rate decisions will be guided by the assessment of the inflation outlook, dynamics of underlying inflation, and the strength of monetary policy transmission. She highlighted that the updated staff projections will be informative in assessing these dimensions in September. BCA Research has suggested that the odds are higher that July’s rate hike marks the end of the European Central Bank’s tightening cycle.

The latest Bank Lending Survey shows that credit standards have tightened in the Eurozone and net demand for loans declined in Q2 of 2023, with corporate loans falling to a record low. See figure 2.

Figure 2

Similarly, contracting M1 and M2 money supply (M1 = coins and currency in circulation + checkable (demand) deposit + traveler’s checks. M2 = M1 + savings deposits + money market funds + certificates of deposit + other time deposits) reflects the impact of the ECB’s aggressive tightening cycle on economic conditions. See figure 3.

Figure 3

At 42.7, the manufacturing PMI in the entire eurozone is at a 5-year low relative to the US, reflecting the tight conditions in the zone. The European Central Bank will be nervous about making a policy mistake by raising interest rates prematurely.

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