Central banks hold interest rates at a scary time

Welcome to this Halloween edition where I am going to focus on shocks. We are in the middle of a flurry of monetary policy meetings across the G7 with no interest rate changes so far. How are important economies coping with the trauma of higher interest rates? And how do central banks view the frightening prospects of a war between Israel and Hamas and much higher long-term US government borrowing costs? A word about the Bank of Japan’s meeting this morning is also below.

A shocking world

It’s time for a shift in tone. After last week’s deserved blast at inflation crimes and misdemeanours, I am going to focus squarely on the emerging thinking within large central banks on the state of the world.

You might think that a series of meetings in which officials stroke their chins and hold interest rates is boring. But I would argue that it is often the opposite. Last Thursday, I found myself entirely in agreement with Christine Lagarde when the European Central Bank president said, “sometimes inaction is action, and a decision to hold is actually meaningful”.

So, what is the meaning emerging from the ECB and the Bank of Canada ahead of this week’s meetings at the Federal Reserve on Wednesday and the Bank of England on Thursday?

First, we need some essential context. The Bank of Canada last Wednesday set interest rates at 5 per cent for the third consecutive meeting. Previously, it had raised interest rates sharply in 2022 before slowing down this year. The ECB, by contrast has doubled borrowing costs this year with the deposit rate reaching 4 per cent in September. Holding rates in October was the first no change meeting since summer 2022.

You can see the inflation dilemma for both central banks in the following chart. If core inflation is a guide to future price rises, Canadian measures (a median and a trimmed mean) were declining nicely, but have become sticky at around 4 per cent since April this year. Eurozone core inflation, excluding food and energy prices, looked much more problematic earlier in the year, but the most recent data for October has shown a sharp decline to 4.2 per cent.

Both central banks, therefore, face a similar problem. Inflationary pressures have not disappeared and it was no surprise that the main policy message was similar on both sides of the Atlantic.

In Canada, governor Tiff Macklem (speaking in English and French) said monetary policy needed to “stay the course”, adding that if inflation remained sticky around 4 per cent rather than the 2 per cent target, the central bank was “prepared to raise our policy rate further”. In Athens, Lagarde (in English only) said that “even having a discussion on a cut is totally premature”, adding that, “the fact that we are holding doesn’t mean to say that we will never hike again”.

The interesting issues are how these two central banks see the global economic environment when we look past their similar problems and monetary stances.

Do the BoC and ECB think higher interest rates are working?

Yes, but not directly through the labour market.

There was no talk about raising unemployment to get inflation down. Instead, Macklem and the BoC focused on signs that households were less willing to borrow and this had led to “softer demand for housing, durable goods and many services”. With interest rate-sensitive spending weakening, he said there was clearly going to be a slowdown in growth, leading to lower inflation. “Demand pressures have eased more quickly than we forecast in July,” Macklem added.

Following the meeting, Lagarde had to note that unemployment in the eurozone was at a historic low of 6.4 per cent in August, so she focused on bank lending to companies, which had become more expensive, she said, leading to a sharp drop in credit growth. “Banks are becoming more concerned about the risks faced by their customers and are less willing to take on risks themselves,” she said.

The message from both central banks was to stop looking only at the unemployment rate because there are other ways monetary policy acts to reduce demand and trim price rises. It is not the strongest argument, but it is the best they have given the data.

How will monetary policy work from here?

Orthodoxy reigns in the BoC and ECB with both banks counting on a period of weak economic performance to lower inflation, but without any talk of a recession.

The BoC was explicit in expecting sub-par economic growth, leading to “excess supply” helping to ease price pressures. It is expecting a second year of growth at around a 1 per cent annualised rate during 2024.

Similarly, in Europe, the ECB expects further weakness in lending, investment and the housing sector to continue into 2024. None of this screams recession, according to Lagarde.

So, the soft landing story is not just a US thing. But if the central banks are wrong and tight monetary policy has a bigger recessionary effect, we could expect both the ECB and BoC to end the period of “higher for longer” interest rates pretty quickly.

What about Gaza?

If the ECB and BoC are almost at one regarding the shock they are imposing on their economies with high interest rates, they differ in their analysis of geopolitics.

The war between Israel and Hamas has two offsetting effects on inflation. It threatens to push energy prices higher, raising headline inflation and could then lead companies and households to defend their interests by respectively raising prices and demanding higher wages. By contrast, weaker global confidence and growth stemming from heightened geopolitical tensions would amplify economic weakness, reducing inflationary pressure.

Although both central banks mentioned these two forces, their focus could not have been much further apart. Lagarde primarily stressed confidence effects damping global growth and highlighted that interest rates were already high, unlike in 2021 and 2022. Macklem took the opposite tack, placing more weight on higher energy prices slowing progress in defeating inflation and saying this would make the BoC more “cautious” in declaring victory over inflation.

The tension over the effect of war in Gaza on inflation is something to watch.

What about rising US bond yields?

Again, the ECB is more dovish than the BoC. For Lagarde, rising long-term US government borrowing costs reflected something nasty being imposed on the European economy from afar. She talked about “external tightening” and factors, “not directly related to the fundamentals of the euro area”. The upshot was that eurozone interest rates might need to be correspondingly lower, she said, calling higher US yields “something that clearly impacts our own rates and we take that into account”.

Macklem passed all questions about the subject to Carolyn Rogers, his senior deputy governor. She was much less willing than Lagarde simply to blame the US. She did not reject the possibility that rising bond yields also reflected a market view about Canada needing to keep interest rates higher for longer to tame inflation. “It’s not a substitute for what the bank needs to do,” she said. Rogers accepted there was a possibility that it could add to monetary tightening, but the message in Ottawa was much more hawkish than in Athens.

So what?

The bar to raising interest rates further in Canada is lower than in the eurozone.

Although both central banks view the effects of monetary tightening to date similarly, their instincts on global shocks are very different. Canada sees inflationary signs everywhere and feels it might well not have done enough, while the ECB tends to focus on reasons global shocks will damp inflation further.

Things to read and watch

• If you’ve not had enough of Christine Lagarde, read Martin Arnold’s lovely lunch with the ECB president, in which she admits having “screwed up” central bank communications in 2020. It probably explains why she is so precise when speaking now, something that does not always aid communication itself.

• My colleague Robin Wigglesworth over at Alphaville had some fun with the Riksbank, highlighting how the Swedish central bank has gone cap in hand to the government, seeking a bailout. He praised the Czechs, who let their central bank run with negative equity by contrast. I don’t disagree with Robin, but it is a topic I will come to come back to as there are a bunch of important public finance and central bank issues to chew through.

• Gita Gopinath, first deputy managing director of the IMF, makes a passionate case for higher taxation to foster sustainable public finances, fund the energy transition and help central bankers in their fight against inflation. She’s right.

• This week, we could not ignore the rampant growth of the US economy, which refuses to slow like the rest of the world, but its latest inflation figures were not as good as recent vintages, as the brilliant Jason Furman explained on X, formerly Twitter.

• A date for your diaries. At the FT’s Global Boardroom between November 8 and 10, you can tune in to Lagarde and Kazuo Ueda, Bank of Japan governor. I will also be making an appearance.

A chart that matters

Core inflation in Tokyo has long tracked that of Japan. Excluding fresh food and energy, it stayed close to 4 per cent in October, much higher than expected. No wonder the Bank of Japan is concerned and relaxed yield curve control this morning, in effect removing the cap it had placed on 10-year Japanese government bonds of 1 per cent. An interest rate rise cannot be far off.

Source: Economy - ft.com