A summer central bank bonanza this week with, in the space of five days, policy decisions from the G3 central banks and China’s Politburo.
Is the Federal Reserve now done?
As expected, the Federal Open Market Committee raised the US federal funds rate by 25bp to a target range of 5.25% to 5.5%, marking a 22-year high.
The latest increase comes after a brief pause in the series of rate hikes at the previous FOMC meeting in June. At the time, Fed Chair Jay Powell had said the central bank would take a more gradual approach to account for months of monetary tightening to cool the economy and contain inflation and for the fallout from the regional banking crisis earlier this year.
With the Fed having raised the benchmark rate 11 times from near zero in March 2022 to over 5%, borrowing costs are now close to a level the Fed deems ‘sufficiently restrictive’ to bring inflation down to its longstanding 2% target in a timely manner.
While our macroeconomic team sees the latest rate increase as marking the end of the cycle, they also expect the Fed’s messaging to be such that a premature loosening of financial conditions can be avoided. The central bank likely wants to retain the flexibility to further tighten monetary policy should prices fail to ease as much as expected.
US labour market will need to cool further
In our view, more evidence of a softening labour market will be needed to eliminate the risk of further hikes. We see this as necessary to shift to the next phase of a sustained steepening in yield curves and a more persistent softening of the US dollar.
The issues of policy lags and lending conditions will have been a topic discussed by FOMC members this week. The 31 July iteration of the Senior Loan Officer Opinion Survey, which we expect to show credit conditions tightening further, should inform the debate at the Fed on whether previous rate rises have fed through to the economy.
Chair Powell raised the prospect of further tightening, even with the fed funds rate close to a sufficiently restrictive level. However, the central bank would decide ‘(policy) meeting by meeting’ whether to keep raising rates based on how the economy fares in the months ahead, ‘with a particular focus on making progress on inflation’.
Markets were mixed shortly after the Fed’s decision. The broad S&P 500 index finished about flat, but still scored its longest win streak since 1987, while the tech-heavy NASDAQ was slightly lower. The benchmark 10-year Treasury bond yield fell.
Has the ECB finished hiking rates, too?
Also as expected, the ECB implemented a 25bp rate hike. It too retains a tightening bias, stating that inflation was still expected to be too high for ‘an extended period’ and that it was determined to ensure that inflation returned to its 2% medium-term target ‘in a timely manner’.
As did the Fed, the ECB spoke of the need for ‘sufficiently restrictive key interest rates’ and stressed that it would base rate decisions on its assessment of the inflation outlook, economic and financial data and the strength of monetary policy transmission. It noted financing conditions had tightened further and were increasingly dampening demand, which should help bring inflation back to target.
Indeed, July’s ECB Bank Lending Survey (BLS) suggested that policy tightening is impacting the real economy. Dovish policymakers may use the survey to highlight the risk of over-tightening and emphasise the importance of lags in the transmission of rate hikes into the economy.
Wil the euro tip the ECB’s hand?
However, the BLS survey on its own should be insufficient to change the course of ECB policy – ultimately, we believe the real economy data (particularly on inflation) will be decisive.
Shifting market expectations significantly, Klaas Knot, a member of the ECB’s governing council, said recently that another hike (after this month’s) would ‘at most be a possibility, and by no means a certainty.’ The ECB, he said, must ‘carefully watch what the data tells us on the distribution of risks.’
His comments then contributed to a fall in the 2-year Bund yield to below 3%, down from 3.33% earlier in July. The yield has risen a little since then, but market sentiment appears to have shifted.
The ECB faces an additional pressure for a more dovish stance from the euro’s appreciation this year. A dearer euro weighs on European exports at a time when the Chinese currency is relatively cheap, and the US dollar is weakening (see Exhibit 1). If the ECB now sounds less hawkish, it may be due to the euro’s strength.
China – No major stimulus package (yet)
China has pledged to step up stimulus as the economy faces what it described as ‘new’ difficulties and a ‘tortuous’ recovery, after a meeting of the politburo of the ruling Communist Party on 24 July.
With the economy having grown at a frail pace in the second quarter and demand weaker both at home and abroad, pressure has been rising on policymakers for more support to shore up the post-COVID recovery.
In the event, the statement issued after the meeting was not ground-breaking: Officials clearly recognise the problems and are ready to step up support further, but still not at the cost of worsening China’s structural imbalances.
As a result, sectors consistent with the government’s ‘new economy’ definition will continue to benefit from policy support. In terms of the ‘old economy’, the one area where more forceful action is likely is the property sector, although details on how any new measures will be implemented and funded will be key.
While the market welcomed the measures set out by the Politburo, most observers appear underwhelmed. The package contained no extensive credit support for property developers, no commitment of additional fiscal resources and no direct consumption boost.
In our view, the market reacted positively to the announcement simply because expectations were not high – no major stimulus had been priced in.