The looming Fed-ECB policy divergence

We now expect the Fed to begin raising rates next June, with a further two 25bp rate hikes in 2022, and three hikes in 2023. This would bring the target range of the fed funds rate back to its pre-pandemic level of 1.5-1.75 by end 2023. Thereafter, we expect a more gradual pace of two hikes per year, with the fed funds rate settling around the FOMC’s neutral estimate of 2.5% by 2025.

What has changed?

Previously, we expected the Fed to begin raising rates in early 2023, on the expectation that inflation would fall back to near the 2% target in the second half of 2022. While we still expect inflation to fall back next year, the broadening in price pressures suggests there is now a significant risk that recent price-setting behaviour becomes more entrenched over the medium term, spurred by a labour market that has proven to be tighter than expected, and correspondingly higher wage growth. On the labour market specifically, we have marked down our expectation for a recovery in labour force participation, with recent research by the Fed suggesting much of the fall has been driven by early retirees, and little sign that the recent end of unemployment benefit top-ups has spurred a recovery in participation. Labour market slack is therefore less than we previously thought. Indeed, on some measures – such as the rate of job quits, and wage growth – the US economy already looks to be at full employment. In any case, we expect the unemployment rate to fall to 4% by Q2 2022, consistent with the Fed’s view of full employment; previously, we expected this to happen in Q4.

With the Fed having already (comfortably) met its inflation goal, and the labour market close to – if not already at – full employment, we expect the Committee to begin signalling an earlier rate lift-off over the coming months. Given previous signalling that the end of tapering of its asset purchases would not be immediately followed by rate hikes, it is possible that the Fed announces a speeding up in tapering at the 14-15 December policy meeting, with asset purchases potentially concluding in Q1 rather than the current Q2 expectation. This would also give the Fed the option of an earlier hike than our June expectation, if monthly inflation readings continue to be as high as the October figure (not our base case).

What are the risks to our view?

Uncertainty is very high, and the risks to our view are significant. That said, risks to Fed policy are likely still tilted to the upside, given the upside risks to inflation itself. On the upside, should elevated inflation drive a run-up in expectations, and wage growth remains elevated, this could trigger a wage-price spiral requiring positive real rates to bring it under control. This implies much sharper increases in nominal rates given the high inflation rate. On the downside, should goods consumption correct to below pre-pandemic trend, this could cause an inventory overhang and a bigger drag from goods (dis)inflation further out. This would likely lead to a pause or slowing in the pace of rate hikes. Another potential brake on rate hikes would be a significant tightening in financial conditions, whether in response to the hawkish shift by the Fed, or to a darkening in the growth outlook.

What does the change in our Fed view mean for the ECB?

We think that the ECB is facing a different set of macroeconomic circumstances than the US central bank and therefore we have not changed our monetary policy scenario on this side of the Atlantic. This means that a hike in ECB policy rates still looks a long way off. Although the ECB will likely end the PEPP in March of next year, the APP will continue and may take the form of a flexible envelope. The rise in eurozone inflation is much more narrowly based, wage growth is subdued and consumer demand is much weaker than in the US. The ECB has also explicitly ruled out a rate hike for at least 2022 and hinted that it could well be on hold for even much longer. This points to a significant policy divergence between the Fed and ECB over the coming years.

The ECB’s outlook will mainly be impacted by the Fed rate hike cycle via market spill overs. On the one hand, the divergence between US and eurozone rates could put downward pressure on the euro, which would raise eurozone growth and inflation, all other things being equal. On the other hand, the rise in US long-term interest rates will also put upward pressure on their European counterparts and therefore tighten financial conditions. In addition, there is the possibility that higher US rates will tighten financial conditions globally, and this would be a negative for global growth and hence also a negative for the eurozone outlook. As such, the impact on the eurozone via market spillovers works in both directions. We will update our market forecasts and calls on the back of the Fed outlook change in the coming days.