This week has been all about the central banks, with the Bank of England, Bank of Japan and US Federal Reserve (Fed) all holding rate setting meetings
The focus has been firmly on the Fed, given the clear signals sent ahead of the meeting that they would be cutting rates, but far less clear signals on the size of the cut.
We have known since late August that the Fed intended to cut interest rates at this week’s meeting, ending a period of 14 months of rates on hold. Fed Chair Jay Powell told the audience at August’s Jackson Hole policy conference that “the time has come for policy to adjust,” noting progress on inflation, and more recently signs of softer activity in the labour market. Messaging on the size of the cut has been less clear, with mixed signals from Fed members on their expectations for the meeting against a backdrop of softening, but not weak, economic data. In the middle of last week, the expectation was a 25bps cut was more likely but several articles in the Wall Street Journal suggested the decision was a close call. The WSJ has previously been used by a conduit for the Fed to fine tune market expectations ahead of rate meetings, so was seen as a signal that a 50-basis point cut was still under consideration. The Fed does not like to ‘surprise’ markets; we usually see the rate decision that prevails fully priced by markets in the days leading up to the decision. Deutsche Bank reported this meeting outcome was the most ‘unknown’ since October 2008 – not in terms of whether policy would change, but by how much it would change.
The Fed decided to go with a 50 basis point cut, taking interest rates to a range of 4.75-5.00%. For the first time since 2005, the decision was not unanimous, with one committee member voting for a smaller cut. The last time the Fed cut by 50 basis points was March 2020, in very different circumstances as the Covid pandemic emerged. This time, the Fed framed the cut as more of a ‘catch up’ with falling inflation, and while they made clear further cuts would follow, their language suggested smaller cuts were likely over the course of the remainder of the year. The Fed statement says they had gained “greater confidence” about inflation even though it remained “somewhat elevated”. The Fed’s projections suggest limited concern over unemployment rising significantly, with the rate of unemployment expected to peak at 4.4% over the next two years, up only slightly from the current level of 4.2%.
The dot plot (which shows expectations of where rates will be in the future) suggests that Fed members do not anticipate further cuts of this magnitude, with two 25 basis point cuts expected over the next two meetings before year end. Fed Chair Jay Powell suggested the decision to cut by a larger amount to begin the easing cycle is a “recalibration” and said that “there is no sense that the committee is in a rush”, adding “I do not think that anyone should look at this and say that this is the new pace for easing going forwards”. This larger rate cut appears very much to be a ‘catch up’ rate cut rather than a signal of what’s to come, and a rate cut from a position of economic strength rather than driven by weakness or market stress. The Fed, as usual, remains data dependent, so another 50bps cut could be seen as more worrying in respect of the economic backdrop. The US economy is undeniably slowing, but at a gradual pace, and the consensus remains that Fed has managed to pull off the elusive ‘soft landing’. History shows soft landings occur after hiking cycles only about 25% of the time, so achieving this would no doubt put Jay Powell into the Central Bankers Hall of Fame.
Yesterday saw the Bank of England keep interest rates unchanged, at 5%, as expected. The Bank said it would take a “gradual approach” to easing monetary policy, assuming there were no material changes in the economy. Governor Andrew Bailey said the economy was evolving “broadly as we expected” and “if that continues, we should be able to reduce rates gradually over time… but it’s vital that inflation stays low, so we need to be careful not to cut too fast or by too much”. The bank appears to be gliding towards another cut, likely in November, but will be conscious of the recent pick up in services inflation (see below). The bank will likely ‘look through’ forthcoming energy price rises, though it predicted CPI would climb to 2.5% by year end. Even so, with interest rates some way above the expected level of inflation, the bank has plenty of room to manoeuvre in bringing down rates to the ‘new normal’ level. Overnight the Bank of Japan made no change to monetary policy, as expected. Their statement warns of “high uncertainties surrounding Japan’s economic activity and prices” and said “it is necessary to pay due attention to developments in financial and foreign exchange markets”. A reminder that the rate hike in Japan in late July was a major factor in the market turmoil at the start of August. Despite inflation at 3%, the Bank of Japan looks to be treading very carefully in adjusting policy higher, not least when other central banks are all cutting rates.
The economic data over the week saw updated inflation data from the UK, with CPI unchanged in August, at 2.2% year on year, as expected. Core inflation picked up slightly, to 3.6% while services inflation climbed higher than expected, to 5.6%. UK consumer confidence weakened in September, likely influenced by the negative tone the new government has taken around the public finances and “painful” budget next month. However, UK retail sales were robust in August and ahead of expectations. The monthly China ‘data dump; was somewhat sobering, with retail sales, industrial production and fixed asset investment all weaker than expected. Before the data was released, the People’s Bank of China issued a rare statement, signalling that fighting deflation would become a higher priority and indicated more monetary easing ahead. With the potential rising for China to miss the 5% growth target set for this year, the narrative around policy easing is getting louder, though the PBoC left rates unchanged in their meeting today.
Markets may well be in a sweet spot for a while so long as the ‘soft landing’ narrative prevails. Historical data shows that equities perform strongly in rate cutting cycles outside of a recession. If a recession ensues, then it’s a very different story. For now, however, with the economic data in the US showing a gentle slowdown, and with more rate cuts to come, the backdrop is most certainly more positive. We still have plenty of political and geopolitical hurdles to get over in the coming months but in the near term, confidence on the economic and monetary policy outlook is likely to be a tailwind for risk appetite.
Source: Bloomberg as at 20 September 2024
