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As far as interest rate decisions are concerned, central banks ended 2022 and 2023 on the same page. Last year, in their pre-Christmas meetings the US Federal Reserve, European Central Bank and Bank of England all raised rates by 50 basis points as they fought soaring inflation. This year, with price growth falling rapidly, they all kept their — now much higher — rates unchanged. But their accompanying festive messages this week hit very different notes. To misquote Leo Tolstoy: all central banks are happy that inflation is falling, but each is unhappy in its own way that it is not falling fast enough.
After waiting too long to tighten policy initially, central banks rightly want to ensure high inflation is comprehensively beaten. The case to keep high rates on hold was indeed strong. In America, although inflation has fallen sharply to 3.1 per cent, its jobs market is still hot and consumer spending is resilient. In Britain, core inflation — which excludes energy and food — is still well above its long-term average at 5.7 per cent. As for the eurozone, while inflation is within half a percentage point of its target, wage growth looks sturdy and further salary settlements next year warrant vigilance.
But with the impact of higher rates still feeding through to households and businesses, the probability of undershooting the 2 per cent target has risen everywhere. The risk, though, is not the same on both sides of the Atlantic. It is perhaps higher in the eurozone, where timelier measures suggest pay growth is already on its way down. On Friday, forward indicators of services and manufacturing activity also pointed to a deeper slowdown ahead. Economic resilience in America and elevated wage growth in Britain suggest core inflation is, however, likely to be stickier in those countries. With that in mind, the signalling from the Fed and the ECB, in particular, seemed off the mark.
The Fed came across as dovish. Its new dot plot of interest-rate projections surprised by implying three 25bp rate cuts in 2024, up from just two. Its forward guidance also watered down the possibility of further increases. But chair Jay Powell also did little to push back on the notion that the Fed is now pivoting to cuts.
With financial markets already on a festive high, after delivering dovish dot plots Powell should have dialled up the caution. Stock markets predictably rallied, with the S&P 500 nearing a two-year high. Bond yields also dropped. These moves amount to a notable loosening of financial conditions — which could be a problem for the Fed if inflation does indeed prove resilient.
By contrast, the ECB president, Christine Lagarde, was hawkish, reiterating that officials “did not discuss rate cuts at all”. But lower inflation forecasts opened the door to a pivot, and reiterated the greater risks of undershooting in the eurozone. The Frankfurt-based bank seems too steadfast, and could now make the mistake of loosening rates too slowly.
The BoE was perhaps most on point with its messaging, though unlike the other two, governor Andrew Bailey did not face a press conference this week. It came across as defiantly hawkish, with three out of nine committee members also voting for a 25bp rate rise. Higher UK consumer confidence and economic activity data on Friday backed up its tone.
With market reactions and policy lags to factor in, pulling off a successful pivot in interest rates is not going to be easy anywhere. Differing economic circumstances, moreover, mean the US, EU and UK central banks will not always be on the same page. But, judging by their end-of-year showing, it is clear that none is totally sure how far or when they will need to make cuts. Here’s hoping they can start 2024 with a bit more clarity.
Source: Economy - ft.com
