2023’s dominant theme has been central bankers’ response to global inflation. Global interest rates have been moved up sharply at a pace commensurate with achieving price stability, at the expense of GDP growth.
At the Jackson Hole Symposium last week, central bankers gave the impression that rates are approaching a plateau. Generally the tone was measured. There was recognition that the monetary tightening so far delivered would take time to feed through.
Inflationary sources transmitted quickly from commodity and post pandemic ‘demand led’ inflation (triggered by pandemic stimulus) initially, to wage and service sector inflation. The effect has been an inflationary spiral that changed expectations, workers now expect annual pay increases close to or above CPI.
Given that both 2022 and 2023 (most likely) are spent normalizing interest rates back to pre-2008 levels, how have these measures been rewarded?
|August 2022/2023||August 2022/2023||Q2 2022/2023||August 2022/
|US||2.5% / 5.5%||6.3%/ 4.7%||2.9% /2.1%||3.7% / 3.8%|
|EU||-0.5%/ 3.75%||9.1%/ 6.1%||0.6%/ 0.3%||6.6% /6.4%|
|UK||1.75%/ 5.25%||9.9%/ 6.9%*||-0.3% / 0.4%||3.5% /3.5%|
|JAPAN||-0.1% /-0.1%||3%/ 2.9%*||0.5% / 6%||2.5% / 2.7%|
Source: CSS Investments Ltd
US – good progress towards 2% inflation objective
Looking at the scorecard, US monetary policy has reduced US core inflation (which strips out volatile items like energy and food) from 6.3% to 4.7% in the last year. US CPI including volatile items is just 3.2%. The US economy has slowed but not stalled, higher loan rates have not prevented the US economy from generating jobs (August +187k) Unemployment has remained almost flat at 3.8% alongside pay rises which amounts to stimulus.
A tight US monetary policy has altered loan demand. According to the Federal Reserve Bank of New York, Americans are spending more on credit cards, balance rose to US$1.03trn (+4.6%) end Q2 whilst mortgage balances fell $30bn in Q2 to $12trn. This suggests US consumers are understandably weary of taking out mortgages with rates at c.7.5%. The data also shows a low rate of mortgage delinquency at just 0.63% (0.44% in Q2 2022). Hence mortgage payments are being met in part via more short term borrowing. A lethargic US housing market has slowed US credit demand and should slow US consumer spending eventually.
Jerome Powell has insisted the Federal Reserve will stay the course and achieve 2% US inflation. On the current trajectory this is possible in 2024, assuming no new global shocks (such as an oil price spike/ wars etc).
Inflation expectations have reduced, the yield difference on the 5 year T-bond (4.23%) and 5 year TIPS (2.09%) (Treasury Inflation Protected Securities) has narrowed to 2.14% hence investors expect inflation to average this level over the next 60 months.
Whilst a further hike in US Federal funds rate is a c. 25% risk we think a flat rate will prevail over the coming 9 months i.e. US rates will remain in the current 5.25%-5.5% area.
EU – measured but slow progress towards 2% inflation objective
EU data shows ongoing inflationary pressures, German CPI at 6.4% (August 2023) remains far too high for the bloc’s largest economy. The German data which underperformed expectations will increase pressure on the ECB to continue its tightening path. Other economies notably France has experienced inflation decline to 4.8% from 5.8% over the last year.
The ECB is likely to raise its refinancing rate at its 14th September meeting from current 4.25% by at least 0.25%. However a larger hike is possible.
The EU’s stubbornly high unemployment and low growth structure is a possible constraint on the ECB – the central bank will not want to tighten policy to levels that cause a severe recession and significantly higher unemployment. It is treading a careful line as Germany is already in recession. However our view is the next ECB rate hike will not be its last.
UK inflation progress has been slow
The Bank of England’s sole mandate is to achieve 2% inflation so UK CPI at 6.9% is some distance away. The timeframe for 2% is now H1 2025. The MPC’s next meeting on 21st September should see a 0.25% hike to 5.5%. The debate now is, will that rise will be enough? Will UK rates plateau at 5.5%? In our view rates > 5.5% would risk a severe UK slowdown.
If history is any guide, the UK tends to get back to low inflation only via recessions and sharply higher unemployment (in the 70s, 80s and 90s). But unemployment has remained at 3.5% and the data is skewed in that whilst 1.4m are ‘unemployed’ there are 5.4m on ‘out of work benefits’ including sickness benefits and universal credit.
Brexit and the pandemic permanently reduced the UK workforce making employers less willing to lose employees. Employees have also become less adventurous. This has led to labour shortages and delays in filling positions. The problem is also structural inflation, automatic pay rises, in both public and private sector and in welfare related spending i.e. the ‘triple lock’ 10.1% uplift in pension payments in 2023. This inflationary source is not particularly sensitive to interest rates. A smaller, older workforce is inherently inflationary and represents a challenge the Bank of England is not equipped to solve.
The house price drop since August 2022 (-5.5%) has accelerated recently (August -0.8%: Nationwide) is a new brake on both GDP and inflation.
Japan – strong GDP rebound will result in rate hikes
As usual Japan has to a large degree been insulated from global trends. The Bank of Japan has left the policy rate unchanged at -0.1% (since 2016) and allowed Yen depreciation. The main beneficiary has been an export boom and higher inflation that the Bank of Japan has tacitly encouraged.
Japan was slower to roll back pandemic precautions and was hit by supply chain disruptions to key components. Over 2022 recovery had been slow. But the economy is now accelerating quickly. In allowing bond yields to rise, currently 10 year JGBs are paying 0.63% the Bank has shown some flexibility however current policy must be nearing an end given GDP growth at 6% (Q2) helped by exports and record levels of incoming tourism.
The Yen’s weakness against the USD will boost inflationary pressures in oil, food and energy imports hence interest rates might have to rise quite sharply if current trends persist. The Yen could be close to bottoming out on that basis. The Bank of Japan will have to adjust rates higher soon.
Global interest rates should peak in either Q4 2023 or Q1 2024. We expect following the peak will be a ‘plateau’ period lasting possibly for 2024.
|Country||Interest Rate||Peak Int. Rate||Confidence||Comment|
|September 2022/2023||Q4 2023- Q1 2024|
|US||2.5% / 5.5%||5.5%||High||At highs already|
|EU||-0.5%/ 3.75%||4.25%||Medium||Another 0.5% hike|
|UK||1.75%/ 5.25%||5.5%||Low||0.25% hike likely|
|JAPAN||-0.1% / -0.1%||0.5%||High||Hike is likely|
Source: CSS Investments Ltd