Powell opens the door for 50bp hike in March; Changes to ECB scenario

Chair Jerome Powell struck a distinctly hawkish tone in his testimony before the Senate Committee on Banking, Housing, and Urban Affairs (see here). He noted that while the Fed had ‘taken forceful actions to tighten the stance of monetary policy’ and ‘the full effects of (…) tightening so far are yet to be felt’ that the central bank still had ‘more work to do’. Indeed ‘the ultimate level of interest rates is likely to be higher than previously anticipated’ given ‘the latest economic data have come in stronger than expected’. He set out two conditions the Fed sees as necessary to restore price stability. First of all, lower inflation in core services excluding housing. Second ‘some softening’ in labor market conditions. Perhaps most strikingly, the Fed Chair noted that ‘if the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes’ which opened the door for a 50bp rate hike at the March FOMC. Our baseline is for 25bp increase at the next meeting, but clearly these comments have put a bigger step into play. The labour market report later this week could be key in this respect. (Nick Kounis)

ECB View: Higher peak, but rate cuts by year end

We have upwardly revised our forecast for the peak in the ECB’s policy rates, while maintaining the view that a rate cut cycle will begin within a year. We now expect the ECB to raise its deposit rate to a peak of 3.75% at the middle of this year, with 50bp of rate hikes at each of the March and May meetings, followed subsequently by a 25bp increase in June. We previously expected the peak at 3% in March. Our baseline now sees a rate cut cycle beginning in December (rather than October before), with 25bp rate cuts continuing through 2024, to an end year level of 1.5%.

There are three reasons for the upward revision. First, although headline inflation has been coming down, core inflation and other measures of underlying inflation – including market implied inflation expectations and pay settlements reached recently - have continued to trend upwards. Current measures of underlying inflation are crucial for the monetary policy outlook. This was very clearly explained by ECB Chief Economist Philip Lane in a recent speech (see here). He noted that ‘the inflation forecast over the next one to three years plays an important role’ but ‘incoming information on underlying inflation constitutes an essential additional basis for assessing medium-term inflation dynamics, in view of the conditional nature, the lower frequency of production and the intrinsic uncertainty surrounding macroeconomic forecasts’.

Second, although the economy is clearly slowing, the pace of slowdown has so far not been quite as strong as expected. The economy performed better than expected in the fourth quarter, while various survey indicators have been improving over recent months (even though their reliability can be seriously questioned). At the same time, unemployment has not yet shown clear signs of an uptrend from current historical low levels. The ECB may feel that without a more sustained weakness in the economy and labour market, underlying inflation may fall more slowly than acceptable.

Third, commentary from ECB officials suggest that a majority is in favour of rate hikes beyond the next meeting in March. For instance, President Christine Lagarde for the first time noted in a recent television interview that ‘it’s possible that we continue on that path’ beyond March. Philip Lane also confirmed that ‘the current information on underlying inflation pressures suggests that it will be appropriate to raise rates further beyond our March meeting’. Though both refrained from giving explicit guidance on the size of the moves beyond March, which would be data dependent.

The case for a pivot

Despite the Governing Council’s guidance that after the peak, policy rates would remain high for some time and possibly restrictive for a number of quarters, we continue to pencil in rate cuts from the end of the year. First, we maintain the view that the economy is entering a period of modest but prolonged contraction. The impact of policy rate changes works with relatively long lags (with a maximum impact of a 100bp hike at around 0.9 percentage points after 4-5 quarters). This likely means that most of the impact of the rate hikes that we have seen and are currently priced for the future is still to hit the economy. As the economy weakens, the labour market will follow with a lag. Over time these trends will curtail both employee wage bargaining power and company pricing power.

Second, although core inflation has surprised on the upside recently, the factors that drove it up have been rapidly reversing. Energy and food commodity prices have been coming down, while supply chain bottlenecks have evaporated. We think we are not too far from the point that this is reflected in a significant downtrend in core inflation.

Third, restrictive policy will no longer be necessary if headline and core inflation are close to target, the economy is struggling and unemployment is rising. Starting the process of bringing policy rates back towards neutral levels would make sense as macro conditions and the balance of risks changes. Indeed, inflation may well be projected to undershoot the target in 2-3 years at the ECB’s December Governing Council meeting.