Central banks have rounded off 2022 with a fresh set of rate rises, in spite of early signs that inflation may be peaking. The Bank of England, European Central Bank and the Federal Reserve announced 0.5% hikes, bringing rates to 3.5% and 4.5% respectively. It is the seventh consecutive rise for the Federal Reserve and ninth for the Bank of England, capping a year that has seen a vast shift in monetary policy.
The rate rises were widely flagged and anticipated by financial markets. Nevertheless, the accompanying comments were closely watched. Fed Chair Jay Powell struck a sombre tone, saying the rate-setting committee would need to see “substantially more evidence” that inflation is abating before reversing course: “It’s good to see progress, but let’s just understand we have a long way to go to get back to price stability.”
Minutes from the Bank of England meeting showed officials were still mindful of the potential persistence of inflationary pressures. They pointed to a tight-labour market and wage increases as areas of concern. Bank governor Andrew Bailey suggested that further increases in rates are likely if there is no break in price rises.
There has been some apparent easing of inflationary pressures recently, which gave the Federal Reserve leeway to raise by 0.5% rather than 0.75% as had been typical in recent meetings. US headline CPI inflation rose 7.1% year-on-year in November, lower than consensus forecasts of 7.3% and a marked fall on October’s 7.7% level. It was a similar picture in the UK, with headline inflation for November at 10.7%, compared to forecasts of 10.9% and lower than October’s 11.1% level.
However, in both cases, it is clear that significant pressures remain. In the US, core CPI inflation, which excludes food and energy, remains persistently high at 6.0%. There are also concerns about wage rises amid a tight labour market. In the UK, there is mounting pressure in the dominant services sector, with annual price rises for restaurants and hotels at 10.2% in November, the highest rate since 1991. This shows how wage rises are filtering through, and with a winter of strikes ahead, there remains a risk of an upward spiral in wages.
While inflationary pressures may start to ease from here, central banks are unlikely to reverse course until they are confident that the inflation genie is back in the bottle. Powell has set three tests that would signal a sustained deceleration in inflation: Core goods prices to keep falling; housing services inflation to follow the private rent price indices down and core services ex-housing inflation to fall. There is evidence of continued progress towards all these goals. However, it needs to build momentum.
A lot of the focus ahead of the Federal Reserve meeting was on how it would guide markets on future rate rises. The medium forecast for the fed funds rate at the end of 2023 was revised up from 4.625% in September to 5.125%. The rate-setting committee also expects interest rates to stay higher in 2023-24.
The bond markets are sceptical that the Federal Reserve will need to tighten as much as these forecasts imply. Current pricing suggests the market believes the Fed will be forced to retreat from further interest rate rises as inflation falls next year, which will pave the way for a ‘soft landing’ for the economy.
It was noteworthy that the Bank of England did not reiterate its comments from the last meeting that the path for interest rates priced into financial markets was too aggressive. Market expectations for peak rates have fallen but remain around 4.5% by next summer, so the tightening cycle to be some way from over. Nevertheless, there remains considerably uncertainty around the outlook for the UK economy and the progress of inflation.
For both countries, the latest set of economic projections gave little cause for optimism. For the US in 2023, GDP growth has been revised lower – from 1.2% to 0.5%. The Federal Reserve is also expecting a higher unemployment rate (4.6% vs 4.4%) and higher inflation (3.1% vs 2.8%). This is some way below the long-term trend growth for the US economy.
In the UK, the picture is worse. The Bank of England estimates that the UK economy is already in a recession although noted it was slightly stronger than their expectations for November. It is likely to register a 0.1% contraction in the fourth quarter, following a 0.5% fall in Q3. The recent fiscal stimulus package announced by the Government last month will bring forward growth, raising the 2023 forecast and weakening the 2025 forecast.
These announcements brought little cheer to markets and dampened any optimism that had built around weaker inflation data earlier this month. Central banks are treading a fine line amid a difficult and uncertain picture for both countries.
All figures are sourced from Bloomberg/Evelyn Partners unless otherwise stated.
 'Emphasise the pain’: Jay Powell keeps hawkish tone even as inflation eases, The Financial Times, 15 December 2022
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