The US Federal Reserve paused its rate-rising cycle this week, the European Central Bank raised its key rates further, and the People’s Bank of China cut rates and signalled more policy easing to come. These moves had been largely expected. However, some smaller central banks recently confounded expectations by raising interest rates, prompting a rise in government bond yields globally.
Central bank policy action is unsynchronised and inflation and growth data is mixed in many countries. Stagflationary clouds continue to overhang financial markets.
There may yet be light at the end of the tunnel should the main central banks’ interest-rate policies shift to easing and if China’s policy easing solidifies economic growth. Such a turn could support corporate earnings and the prospects for equity markets.
For now, however, markets will likely continue to yo-yo between risk-on and risk-off trades in the short term, reflecting fickle investor sentiment and conflicting growth and inflation signals.
Message from the smaller central banks
Last week’s 25bp rate increase in Canada came after a two-meeting pause in the Bank of Canada’s (BoC) rate-rising cycle. It followed a decision by the Reserve Bank of Australia to raise its policy rate, too, by 25bp. The moves boosted bond yields globally and hit equity market sentiment.
The message from the BoC was clear: A rate policy pause does not necessarily mean that rate cuts will follow if inflation does not behave according to central bank expectations. Indeed, both the BoC and RBA cited upside surprises in core inflation as the justification for the rate increases.
Stuck between a rock and a hard place
Despite 10 consecutive rate rises by the Fed, the US economy is continuing to grow and inflation has remained comparatively high. Real GDP grew by 1.3% year-on-year in Q1 2023 and core CPI inflation was still more than 5% in May – well above the Fed’s target.
However, initial claims for jobless benefits for the week ending 3 June surprised the market, rising by 28 000 to 261 000 and marking the highest level since October 2021 (see Exhibit 1).
Although the actual claims level is still low by historical standards, the recent increase suggests some softening in a tight labour market. If this persists, it would mark a development that is to the Fed’s liking and one that could help the central bank justify holding off on further rate rises.
The latest ‘dot plot’ of projections by policymakers at the Fed though showed a strong consensus that two more rate hikes would be needed this year to help bring inflation down to target. The Fed’s projections for the economy were upgraded: faster growth and robust core inflation are now forecast for 2023. The Fed’s forecast show the bank believes the economy can avoid recession even as inflation falls.
Eurozone recession, but booming employment
The eurozone economy has had a technical recession, with two consecutive quarters of negative GDP growth through the first quarter of this year. Germany is faring the worst within the bloc, with its economy shrinking by 0.5% quarter-on-quarter in Q4 2022 and by 0.3% in Q1 2023.
The surprise is that employment is still expanding robustly, rising by 0.6% QoQ in Q1 2023 in the eurozone and by 0.3% in Germany. The combination of a tight labour market and stubborn core inflation remains a headache for the ECB: “Inflation … is projected to remain too high for too long. [We are] determined to ensure that [it] returns to its 2% medium-term target in a timely manner,” the central bank said of its latest policy decision. “Indicators of underlying price pressures remain strong.” It added staff projections for core inflation had been revised up and cited a ‘robust’ labour market.
Headline inflation has nonetheless been falling as previous rate hikes work their way through the economy. “Tighter conditions are a key reason why inflation is projected to decline further towards target, as they are expected to increasingly dampen demand”, the ECB noted.
However, the outlook for core inflation remains uncertain. That is why the ECB had so far signalled only that the policy rate cycle might be peaking. ”Interest rate decisions will continue to be based on the assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of [core] inflation and the strength of monetary policy transmission,” the ECB reiterated.
Uncertainty in China
Recent bearish investor sentiment on China is likely a result of previous growth expectations that proved to be too optimistic. Indeed, most of the data still points to steady expansion: imports showed an improvement in domestic demand in May, with shipments rising by a monthly 0.2% in volume terms. However, exports fell (as expected).
China lacks the inflation problem of the other major economies (see Exhibit 2). Core consumer price inflation rose by only 0.6% YoY in May and producer prices contracted by 4.6%. Economic growth is nonetheless not as strong as the government would like and China looks set to ease its policy rates further. Indeed, the PBoC cut some key rates on 13 June and the government signalled that more easing measures were to come, including further support for the real estate sector and ‘window guidance’ for banks to cut interest rates.
To boost and sustain the momentum of its economic recovery, Beijing is initiating another round of policy easing with measures to boost consumption and private sector investment. They include a relaxation of home purchase restrictions, targeted liquidity injections into the property market, additional infrastructure investment and targeted consumer incentives.
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