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After a hiatus over the past few weeks, global central banks are moving back to centre stage. This week, we saw the ECB hike its key policy rates by 25bps, lifting the deposit rate to a record high of 4.0%. The decision was always going to be a close call, but after some leaks of the ECB inflation forecasts, markets had shifted to pricing in around a 2/3 chance of a hike prior to the meeting.
While President Lagarde refused to rule out further hikes from here and reiterated a data-dependent approach, the post meeting statement and associated press conference hinted that the ECB have likely reached the peak in rates given their current outlook. In particular, the statement highlighted that “based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target. The Governing Council’s future decisions will ensure that the key ECB interest rates will be set at sufficiently restrictive levels for as long as necessary.”
In essence, it appears that absent a further inflation surprise, the ECB is likely to shift its focus from how high to take rates, to how long to keep them at their current restrictive levels. Given the outlook for underlying inflation, rates are likely to remain at their current levels for an extended period. Notwithstanding a modest downgrade to their core inflation forecasts since June, the ECB expects core inflation to average 5.1% in 2023, 2.9% in 2024 and 2.2% in 2025. In other words, the ECB is not forecasting a return of inflation to its 2% target until after their forecast horizon, most likely in 2026.
The ECB is projecting inflation to remain above-target despite increased signs of forceful transmission of its prior rate hikes and faltering economic growth. The ECB revised down its real GDP growth projections to 0.7% in 2023 (was 0.9%), 1.0% in 2024 (was 1.5%) and 1.5% in 2025 (was 1.6%). While the ECB is expecting the region to narrowly avoid recession, it is expecting the economy to stall in H2 2023, with flat growth forecast in Q3 and growth of just 0.1% Q4.
QIC’s euro area growth outlook is similar to the ECB’s projections, although a touch softer. Our September forecasts expect real GDP growth to average around 10bps below the ECB’s forecasts each year at 0.6% in 2023, 0.9% in 2024 and 1.4% in 2025. Similarly, our core inflation forecasts are also around 10-20bps below the ECB’s projections at 5% in 2023, 2.8% in 2024 and 2% in 2025. Given this softer outlook, we expect rates have peaked and the ECB should be able to keep the deposit rate at 4% from here. Prospects for monetary policy easing remain a long way off, and we don’t expect any cuts until June 2024, although we wouldn’t be surprised if this gets delayed to Q3 2024. This is not too dissimilar to current market pricing, which expects no further hikes by the ECB and has priced around an 80% chance of a cut by June next year.
Next week, we’ll shift our attention to meetings by the US Federal Reserve and Bank of England. The US Fed is widely expected to keep rates unchanged after the CPI report this week confirmed an ongoing gradual trend moderation in core inflation. Despite a stronger headline print due to a 10½% jump in gasoline prices, the annual rate of core CPI inflation eased from 4.7% to 4.3% in August. Recent momentum has been even more promising, with inflation in the three months ending in August running at a 2.4% annualised pace. QIC continues to expect the US Federal Reserve has already reached the peak in the federal funds rate at 5.25-5.5%, although we expect the Fed will retain a tightening bias and its data dependent approach given the surprising resilience in economic activity over recent quarters.
The Bank of England is widely expected to hike rates by 25bp next week to take the Bank Rate to 5.50%. Ongoing signs of strong wage growth, with average weekly earnings up 8.5% over the past year, is likely to force the BOE to tighten rates further despite signs of weakening growth and rising unemployment. While a hike next week by the BOE is expected by both QIC and the market, more uncertainty exists around whether this will mark peak rates for the UK. QIC had been expecting a further hike in November given elevated inflation pressures, but MPC members have been sounding increasingly dovish over recent weeks and we will be watching for any signs to suggest that the BOE may have also reached peak rates.
One country that is nowhere near peak rates is Japan. Following the BOJ’s move to introduce a more flexible yield curve control policy in July, Governor Ueda surprised markets over the weekend by suggesting that the central bank could end its negative interest rate policy when achievement of its 2% inflation target is in sight. He went on to suggest that the central bank could have enough data by year-end to reach this decision on ending negative rates. QIC were surprised by these comments from Ueda, as we were expecting the BOJ not to lift rates until 2025. While we are concerned that premature hiking by the BOJ could jeopardise the progress made in lifting inflation expectations, it appears increasingly likely that the BOJ is seeking to prepare the market for a potential hike in H1 2024.
Given the surge in inflation seen following COVID, no central bank is going to stridently declare that policy is now sufficiently restrictive to return inflation to target. Rather, central banks will emphasise a data dependent approach and a commitment to do whatever is necessary to return inflation to target. However, reading between the lines, most western central banks are becoming increasingly comfortable that we are near the peak in rates. The question then becomes, how long to keep them there? That is likely to become the dominant theme confronting markets in 2024.