February 01, 2023
Finding the Summit
February 01, 2023
When preparing for a mountain summit, skilled hikers understand that navigation, communication, and survival skills are essential for success. Navigation skills help hikers to understand where they are and where they are headed. Basic survival skills help hikers read weather clouds, particularly the shape of those clouds and the implications for incoming weather. Communication skills are also required to relay information, warn others of impending dangers, and share the direction taken and when the journey might end. As central banks near their “peak” rates, they are charged with having similar skills-navigating, communicating and reading the “weather charts” to understand if they should forge ahead towards the peak or turn back forcing them to abandon their summit climb.
In 2022, 10 major developed market central banks hiked rates a combined 113 times1 bringing the total rate hike to 2,825bps. While the pace and scale of the rate hikes was unprecedented for many economies, the summit has likely not been reached and persistent inflation along with continued strong signals from the labor markets requires further central bank hiking actions until the peak is reached. As we turn the calendar to 2023, the Bank Of England, ECB, and Federal Reserve have acknowledged that signs of softening inflation and slowing economies may be surfacing, however upside risks remain and investors should not be complacent against higher rates as central banks step down the pace of tightening:
BANK OF ENGLAND – after raising rates 325 basis points in 2022, the BOE still has more work to do as a mix of shocks which the UK has experienced over the last few years—labour supply shortfall, global supply chain disruptions, and higher energy prices, may imply more persistent inflationary pressures and a more forceful policy response. While a correction in the housing market appears to be underway and sign of labour market slackening have begun, chronically high inflation prints will require the BOE to continue its march towards a peak policy rate of 4.50% with risks tilted towards the upside if inflation prints fail to moderate in the first quarter. Clouding the picture is a labour market where a shortage of workers which has led to a declining participation rate, labour strife, and an aging population which has led to wage pressures as higher inflation has curtailed consumer purchasing power.
EUROPEAN CENTRAL BANK – after raising rates 300bps in 2022, the market expects the ECB to increase rates another 150bps by the summer of 2023. With inflation surging above 10% in Q422, tight labor markets, and signs of stronger wage growth, which has lagged inflation, ECB officials remain adamant that they have more ground to cover and longer to go in their fight against inflation. While lower energy prices, China’s reopening, and warm weather have led to a more resilient European economy, tight labor market conditions have prompted worries from ECB officials that inflation will remain above the ECB’s target until 2025.
FEDERAL RESERVE BANK – Markets continue to perceive the Fed’s terminal rate as less than 5% even as Federal Reserve officials reiterate concerns that inflation remains elevated and more work may be required. While recent measures of inflation have softened, a strong labor market and relatively easy financial conditions are complicating the Fed’s effort to bring inflation durably lower. As the FOMC moves closer to what they view as peak rates, the Fed will be looking for compelling signs that inflation is on a firm downward path or, if not, that rates will need to be held at a higher level for longer to help ensure that inflation returns to the central bank’s 2% target. Once the Fed reaches the peak, the market believes the Fed will quickly reverse course a view which is inconsistent with central banker rhetoric. At the very least, we believe that the market interest rate expectations need to increase and come closer in line with the Fed messaging and projections as service wage inflation appears to remain elevated.
As the calendar turns to a new year, developed market central banks will continue to push forward with monetary policy actions to reach their peak rates. Further central bank messaging will likely become more nuanced as inflation pressures moderate and the BOE, ECB, and Fed communications signal slowing the pace of policy rate increases. For example, across economies while inflation is moderating, labor pressures remain as the effects of Covid, early retirement, and continued strong service labor demand could pressure inflation higher. As the clouds of goods and housing inflation dissipate, the implications of labor market strength may signal whether central banks will need to forge ahead to the summit. Investors, similar to skilled hikers will need to pay attention to the weather clouds and how those clouds may foreshadow forthcoming changes either in the weather or on central bank policy as they move towards the summit.