As we move into the summer, recent economic indicators have not really helped investors to determine whether the global economy is in good shape. Leading central banks appear set to continue tightening their monetary policy. Indeed, several of them have surprised recently by hiking more than expected, fuelling investor nervousness about tenacious inflationary pressures.
Live from Sintra
In June, several central banks announced unexpected – or larger than expected – policy rate increases: Australia (+25bp) and Canada (+25bp) at the beginning of the month; the UK (+50bp), Norway (+50bp) and Switzerland (+25bp) last week. They unanimously stressed the need to ensure price stability in the medium term at a time when inflationary pressures show little sign of subsiding.
Mid-month, the US Federal Reserve (Fed) paused on hiking rates after ten straight increases while the European Central Bank (ECB) raised its policy rates by 25bp – both decisions were in line with market expectations. Both Fed Chair Jerome Powell and ECB President Christine Lagarde made it clear that the tightening cycle was not over.
Among the developed economies, only the Bank of Japan seems to want to steer clear of policy tightening. While many observers had thought the BoJ might adjust its yield curve control policy at its July meeting, two monetary policy committee members suggested this would not be helpful in the near future. This came as a surprise given that Japanese inflation, excluding fresh food and energy, rose 4.3% year-on-year in May, marking its highest level since June 1981.
By (perhaps well-orchestrated) chance, Bank of England Governor Andrew Bailey, Christine Lagarde, Jerome Powell and BoJ Governor, Kazuo Ueda, participated together in a panel discussion on 28 June at the ECB’s annual Forum on Central Banking in Sintra. The theme? Macroeconomic stabilisation in a volatile inflationary environment.
Rise of the hawks
Their comments at the event confirmed recently expressed views.
- Jerome Powell: “I do not see US core inflation returning to 2% this year or next, but in 2025.”
- Christine Lagarde: “We are not seeing enough tangible evidence of the fact that underlying inflation, particularly domestic prices, is stabilising and moving down.”
- Andrew Bailey: “The cumulative data – both on the labour market and on the inflation release we had, which to us showed clear signs of persistence – caused us to conclude that we had to make really quite a strong move.”
- Kazuo Ueda: “The central bank would see good reason to shift monetary policy if it became ‘reasonably sure’ that inflation would accelerate into 2024 after a period of moderation. But we are less confident about the second part of this scenario.”
It’s inflation – Front and centre
Initially, central banks claimed the rise in inflation was ‘temporary’. Then they saw it accelerate sharply, so they hiked their policy rates aggressively and waited for early signs of inflation slowing.
Now, central bankers (except the Bank of Japan, but you’ve probably got the idea by now) want to see strong evidence of such a slowdown and be sure it will not re-accelerate in the near future.
We hear their message. And, while we remain convinced that the surprising resilience of the US economy will eventually give way to slower growth towards the end of the year, and that the eurozone will still see several quarters of modest GDP growth, we do not foresee any cuts in key rates anytime soon.
To start with, the tightening cycle is not entirely over (although the end is approaching). In addition, persistent core inflation will likely lead central banks to keep their monetary policy restrictive (that is, above the neutral rate) even should economic growth soften.
The time for ‘pre-emptive’ monetary policies is long gone: The argument about the lag (usually estimated at six months) between action on policy rates and effects on the economy will likely not be used to trigger any easing before policymarkers are sure that inflation has returned to the 2% target.
As such, a slowdown in private sector credit growth in the eurozone and the repayment of targeted long-term refinancing operations (TLTROs) will likely not lead to an ECB monetary policy ‘pivot’. Since last November, banks have redeemed EUR 1 489 billion of TLTROs (including EUR 506.3 billion on 28 June). This could eventually lead banks to tighten their lending conditions, even if excess liquidity remains abundant.
Should we still monitor economic activity?
Of course, but we should do so while realising that in the coming quarters, central banks will monitor movements in the prices of goods and services very closely (‘dissect the analysis’, to quote Christine Lagarde). The latest news from eurozone countries is encouraging, with inflation for June slightly below expectations in Italy, Spain and several German Länder. Beware, however: One swallow does not make a Summer; equally, one or two data points do not create a trend.
Only a few months ago, investors would probably have interpreted such data coupled with the deterioration of eurozone business surveys as a reason to revise down their expectations of a further rise in key rates.
Flash eurozone purchasing managers’ indices (PMI) published in late June showed a sharp decline in the composite index from 52.8 to 50.3 (its lowest since January), with the decline seen in both manufacturing and services.
The decline in the services sector index was dramatic in France (from 52.5 to 48, its lowest in 28 months). At the same time, French household confidence recovered, but the index remains well below its long-term average (even below the levels reached during the pandemic) and the industrial business climate is little better than in May.
On a historical basis the level of PMIs in the second quarter corresponds to a contraction in GDP of 0.5%, although in its latest economic outlook, France’s National Institute of Statistics and Economic Studies (INSEE) forecasts modest GDP growth for the rest of the year – 0.1% in Q2 and Q3 followed by 0.2% in Q4. The Banque de France expects a 0.1% rise in the fourth quarter.
In Germany, the manufacturing PMI fell to 41, its lowest in 37 months, and the services index fell from 57.2 to 54.1, a 3-month low. The business climate as measured by the Ifo Institute also fell, especially for the component that reflects the outlook. The indices erased all the improvement since the start of the year and the levels reached in June corresponded to a recession in the German economy. Even so, the Bundesbank expects GDP to have risen slightly during the second quarter.
When growth is this sluggish, it is preferable to avoid inflation!
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