With the ECB having eased monetary policy again, the focus is now on the pace of cuts from the US Federal Reserve. Will policymakers go slowly first and cut rates by 25bp? Or do they consider inflationary pressures as definitively vanquished and seek to stave off any recession risks by opening with a 50bp cut?
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ECB proceeding cautiously
The governing council of the European Central Bank met on 12 September. As expected, a cut in the key benchmark deposit rate from 3.75% to 3.50% was agreed. The post-meeting communication madeno pre-commitment to a specific trajectory for policy rates in the coming months. The emphasis remains on data dependency.
The ECB published new projections (click here for the full details) showing a 10bp downward revision to growth for each of the next three years. Risks are still seen as tilted to the downside. The main surprise was inflation. Despite euro appreciation and lower oil prices (see Exhibit 1 below), the path of the ECB’s headline inflation forecast is unchanged and was not revised down.
We see monetary policy in the eurozone as restrictive, with real rates at around 1.5% now well above the neutral rate (which we estimate to be at most 1%). Although another rate cut in October is formally on the table, there appears to be a high bar for it to occur. There is neither much time nor new data to be released that would enable members of the governing council to form a consensus before the next meeting on 17 October.
For these reasons, we see the next rate cut as more likely in December. If the outlook for inflation looks to be softer in 2025, December could also bring a reassessment of the easing path. As of now, the risks to the ECB’s inflation outlook are that their forecast is too optimistic. A faster pace of cuts (say from December until April) could take the form of back-to-back cuts until the policy rate arrives closer to the neutral rate.
The most important message we take from the projections is that the ECB’s conviction that wages and core inflation will meaningfully decelerate in 2025 is fully intact. The pace of further easing of monetary policy will depend on how the eurozone economy performs in the coming months.
Disinflationary winds from China
The run of feeble economic data in China has continued. After soft purchasing managers’ indices, recent inflation, trade and credit data have come in weaker, too. Industrial output grew at its slowest pace since March, while retail sales had their second-slowest month of the year. Annual inflation is running well below 1%.
Former People’s Bank of China (PBoC) Governor Yi Gang said China should focus on ending deflation, an acknowledgement by a prominent figure in China that falling prices are threatening the country’s growth outlook. Excess capacity in China means that the country continues to export disinflationary pressure globally, especially to developed market trading partners.
Domestic demand is weak in China while exports are rising. Credit growth also dropped to a new record low in August. The credit impulse points to a further slowdown in activity ahead. One consequence of China’s housing crisis seems to be a two-speed economy, with exports increasing rapidly – real exports are up by 14% over the past year – while domestic demand softens. China may face more tariffs from trading partners if the goods trade surplus keeps on expanding.
The domestic CSI 300 index has fallen by about 7% this year. While valuations of Chinese stocks are attractive, trading at an average price/earnings ratio of about 11x, the recovery of China’s housing market appears to be following the pattern previously seen in other countries, with a prolonged period of stagnation before any recovery.
President Xi has called on officials to strive to hit this year’s growth target of 5%, and the PBoC has also vowed more policy support. Given that it is already mid-September, officials will have to act very quickly to keep the official GDP target for 2024 within reach.
How fast does the Fed go?
Against a background of subsiding concerns about inflation but rising worries about the state of the US labour market, the US Federal Reserve is poised to embark on the first in a series of expected interest rate reductions. After over a year with the key federal funds rate at a level of 5.25% to 5.5%, the Fed is seeking to stave off any further deterioration in the US labour market and engineer a soft landing for the US economy.
We evaluate the neutral rate for policy rates in the US to be around 3%. The question now is how quickly the Fed eases monetary policy back to this level. After a series of press articles last week suggested the Fed’s options were open, futures markets have moved from anticipating a 25bp cut last week to now pricing the probability of a 50bp cut at 70%.
Data has been mixed since the Fed’s meeting in July. Last week’s release of consumer price inflation data showed a fall in the headline number from 2.9% to 2.5% year-on-year but a modest rise in core inflation. After a weak July jobs report, job growth was again viewed as soft in August, though the unemployment rate ticked slightly lower. Job creation was concentrated in only a few sectors, raising questions about why companies are scaling back on hiring at a time of solid economic growth.
Neither the option of a 25bp cut, nor a larger ‘safety-first’ style 50bp cut are likely to have unanimous support within the Federal Open Market Committee (FOMC). The decision on rates will be accompanied by a set of economic projections and an updated ‘dot plot’ aggregating officials’ individual forecasts for the policy rate. If the Fed leads with a half-point move, markets will expect at least two more quarter-point cuts at each of the remaining meetings in 2024.
We see US economic growth on course for a soft landing, with 75bp of rate cuts this year followed by further cuts next year, taking US monetary policy close to neutral by the end of 2025.
Disclaimer
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
