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It has been a difficult week for the small army of economists at the European Central Bank. Many will be reeling from the tongue-lashing they received from their President Christine Lagarde in Davos, calling them and most other dismal scientists a “tribal clique” who do not think outside their small world (watch at 13:30 minutes in). There is evidence some bad feeling is mutual. Were her words correct and wise? Email me: firstname.lastname@example.org
The interest rate landscape
Central bankers have given many interviews and speeches in the past week, and one unifying feature is that officials hate U-turns. They would prefer to wait, act slowly and risk being late rather than reverse course. As Krishna Guha, vice-chair of Evercore ESI, put it:
What we think some in the markets have been missing — or not putting enough weight on — is the central banks’ shared fear of starting too soon and having to stop or reverse course.
Some examples of this tendency include Christopher Waller, the Federal Reserve governor, speaking last Tuesday, who said:
The key thing is the [US] economy’s doing well; it’s giving us the flexibility to move carefully and methodically; so we can see how the data comes in, see if progress is being sustained. The worst thing we’d have is if it reverses and we’d already started to cut [rates]. (21:00 minutes in)
He was echoed by Lagarde last Wednesday:
The risk would be worse if we went too fast [with rate cuts] and had to come back to more tightening because we would have wasted all the efforts that everybody has put in the last 15 months. (30 seconds in)
As central banks meet for monetary policy decisions over the coming 10 days, we therefore have to expect officials to be in wait-and-see mode. That said, each of the four major western central banks have their own specific challenges to address.
Bank of Japan
The Bank of Japan is different in two respects. It is considering an interest rate rise rather than cuts and has already finished its meeting. Contrary to many economists’ predictions last autumn, the BoJ again left interest rates at -0.1 per cent and did not signal an imminent end to its policy of negative interest rates.
It also left yield curve control unchanged, having loosened it in October, to have 1 per cent as a reference point for 10-year Japanese government bond yields rather than as an upper limit. This reference point is currently not binding.
The main reason for the BoJ’s caution is that inflation and wage growth data have been weaker than expected, casting doubt on the BoJ’s ability to hit a 2 per cent target sustainably. The Committee still expressed confidence that after weaker energy prices lowered inflation in the 2024 fiscal year, a “virtuous cycle” between wages and prices would emerge, ensuring inflation would stabilise around the 2 per cent target rather than falling below.
The BoJ’s confidence here is low, however, and it wants more evidence before ending negative interest rates and raising the policy rate. A symbolic rate rise to zero per cent in April is still expected, but it is a close call and will depend heavily on wage data in the coming months.
The Federal Reserve is probably in the best position, ahead of its rates decision on January 31, because inflation is moderating without an economic downturn. There will be no explicit policy change and the main focus will be the signals sent by the Federal Open Market Committee regarding the speed and number of interest rate cuts to come this year.
Financial markets have expected the first cut in March and five further reductions in 2024, while the FOMC’s economic projections from December suggested only three quarter-point rate cuts were likely.
The key issue is that Fed governors want evidence if they are to cut rates faster or more extensively. This would require inflation falling more rapidly and sustainably than expected or some bad news on jobs from the labour market. While there is plenty of time before the March 20 meeting for this evidence to arrive, we have not seen it yet.
Markets are beginning to take note. Accordingly, the CME Group FedWatch Tool now has a less than 50 per cent financial market expectation of a March rate cut. As the chart shows, the Atlanta Fed market probability tracker for March 2024 still gives an 80 per cent chance of a rate cut. The difference arises because, while the Atlanta Fed uses a more sophisticated algorithm to generate the probabilities, it bases them on three-month options in the secured overnight financing rate (SOFR) market, a period starting on March 20 and ending on June 18. Nearly everyone expects a rate cut by the June meeting.
European Central Bank
The headlines last week suggested that the ECB was rejecting the popular idea in financial markets that it would cut rates in the spring, but the reality was more subtle. For sure, Lagarde said she wanted to avoid cutting rates too early, but she also said that it was reasonable to think the central bank would cut its rates by the summer if there was not a further inflationary shock. Previously, her blanket response was that it was far too early even to talk about rate cuts, so her new statements were an acknowledgment that policy priorities are shifting in Frankfurt.
The key reason for the delay was to give the ECB time get sufficient evidence in late spring that high wage growth did not present a continued inflationary threat. The eurozone does not have a comprehensive, accurate and timely measure of wages, but they are growing much faster (at about a 5 per cent annual rate) than a rate consistent with the 2 per cent inflation target.
However, as Philip Lane, ECB chief economist, has noted, there can be a period of wage catch-up after an inflationary episode to rebalance profits and wages, dependent on trends in productivity and import prices. As the chart shows, nominal wage levels have fallen significantly below price levels in the eurozone on all main measures and some catch-up in wages is justified. It is therefore likely that the ECB will wait, but a weakening in the economic outlook would prompt an earlier move if it was also paired with further good news on inflation.
Bank of England
In many ways, the BoE has the biggest task ahead in its meeting on February 1. It needs an entirely new economic narrative to accompany its refreshed economic forecasts that are bound to change significantly.
With inflation in the final quarter of 2023 much lower than expected and energy prices well down on the Monetary Policy Committee’s November forecast assumptions, CPI inflation is now likely to fall back to the BoE’s 2 per cent target in the April or May data this year. In the November forecasts, the MPC thought it would achieve this milestone only at the end of 2025. The key conditioning assumption changes are shown in the following chart.
The change in the outlook is likely to lead to an end of votes to raise interest rates further from the three hawks on the MPC who voted to raise rates from 5.25 per cent to 5.5 per cent at the December meeting. Jonathan Haskel has already indicated a change of view on X.
As the chart shows, market expectations have priced in four quarter-point rate cuts this year and another three next year.
The MPC is likely, therefore, to perform a pivot at this meeting. Two questions arise. First, whether the MPC implicitly validates the forward curve in its new inflation forecast, suggesting interest rate cuts as soon as May. Second, whether Andrew Bailey can manage to present the huge forecast revisions as a triumph of policy or whether it is seen as another blunder by the BoE. This has to be his best chance yet to score a communications victory. But, with the BoE, you never know.
What I’ve been reading and watching
My newsletter about the lack of evidence proving the “last mile” of inflation control is the hardest received academic support from the Atlanta Fed. “After examining a number of potential mechanisms, it is difficult to conclude that the last mile of disinflation is more arduous than the rest,” the paper by staff member David Rapach concludes.
In a speech on Monday, Agustín Carstens, the often hawkish head of the Bank for International Settlements, said he now viewed the economic landscape with “cautious optimism”, saying inflation did not get embedded as he had feared. Obviously, he added that success must not breed complacency.
In her column, Soumaya Keynes wonders how a new Trump presidency would affect the Fed. She’s exactly right to expect jawboning to keep interest rates down and ultimately a new Fed chair. There is not yet a settled name for a Republican replacement of Jay Powell in 2026, so a lot to play for and quite a bit of concern given some of the names she mentions.
Over at the Long View, Katie Martin notes there seems to be only one thing that matters to financial markets this year — the path of interest rates. All the more reason to follow this closely.
The Office of Inspector General, which oversees the Fed, has issued a long-awaited report into the trading activity of two former top Federal Reserve officials, Robert Kaplan of the Dallas Fed and Eric Rosengren of Boston — both of whom resigned in 2021. Their trades created an “appearance of conflict of interest”, it said, although its main conclusion was that no laws were broken or lasting damage done.