Strategy blog: A monetary round-up

Last week's unsurprising policy moves at the four western central banks we follow most closely – the big three and the Swiss National Bank – took the total interest rate increase in the last twelve months to almost twelve percentage points, an average of three points each. The Fed led the way (a cumulative move of 4.25 points), followed by the Bank of England (3.4 points), the ECB (2.5 points) and the SNB (1.75 points).

Policy rates for the ECB and SNB are now firmly back in positive territory in nominal terms, and were not negative at the Fed or BoE to begin with. We are at or close to "old normal" levels. But when current policy rates are compared to the latest core inflation rates (that is, inflation excluding likely "transitory" food and fuel components), all four continue to preside over negative real interest rates – a reminder that inflation is too high for comfort. Real interest rates on this basis are most negative at the ECB and Bank of England, and least so at the Fed and SNB.

Generally, the central banks have not covered themselves with glory in this inflationary episode – they partly caused it, and were very slow to acknowledge it. But if there were prizes for monetary credibility in 2022, the following might be appropriate…

  • "Least reckless": the SNB. Core inflation only just nudged above 2%, the real policy rate didn't reach -3%, and today's real rate is least negative, at -0.9%. The SNB would also win the "Leaving the nest" award for stepping out of the ECB's shadow and raising rates independently in June. In accepting its award, the Swiss bank would likely pay tribute to the important supporting role played by the franc.
  • "Quickest study": the Fed. As recently as August 2020 the Fed was rolling out a modified monetary policy which would allow the economy to run hot for a while, targeting an average inflation rate over an unspecified period of time. This year, faced with a negative real policy rate of -6%, it quickly dropped its pretensions, talked tougher and added those 4.25 points to nominal rates: 2022 ends with the real policy still negative, but at "only" -1.5%. Like the SNB, though, the Fed would want to say thanks to its currency.
  • "Savviest operator": the ECB. Faced with the most challenging economics – supply-side disruption on its doorstep – and having (as always) to walk a political highwire, the ECB was decisive in changing the "see no inflation" rhetoric with which it started the year. Its first act was a 50bp hike in the summer, followed by two 75bp moves and now another 50bp. And this without any help from the euro (until very recently).
  • "Most polite": the Bank of England. Not wanting to offend anyone, the Bank played granny's footsteps for much of the year. To be fair, it presides over the biggest pool of flexible-rate mortgage debt, and had no help from the pound (until recently) or its unruly fiscal neighbours.

We doubt any of the four have yet finished raising rates. Inflation – headline and core – does seem to be rolling over, but it is still uncomfortably high (outside Switzerland) and economies remain close to full employment. Credibility needs to be rebuilt further. But another 50-100bp might be all that is needed to complete the normalisation process, for this cycle at least.

This is nonetheless a little more than money markets are pricing in (in the US, at least). And whereas the markets see rates starting to fall again relatively soon – by the end of 2023 in the case of the Fed – we are sceptical. This leaves us thinking that the long-term real yields priced into bond markets, in particular, are still on the low side. Long-dated nominal yields were higher briefly back in the autumn, allowing us to advise closing a long-standing wariness towards bonds in USD portfolios at least (UK gilt yields spiked most dramatically, but if you blinked you missed it). But they have more recently fallen back – and with longer-term inflation expectations broadly stable, it has been real yields that have moved most and now look expensive once again.

The markets may think that an economic emergency is more likely. But as we note in "Market Perspective", a slump – as opposed to a "typical" recession, the probability of which may be too close to call – is not inevitable. The supply-side of the global economy may prove more flexible than feared, even as wages rise and industrial unrest spreads. Such an outcome might be an inflationary "get out of jail (almost) free" card perhaps, but after recent monetary hubris it is not one we would encourage the central banks to play.

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