Taking stock of a big week for central banks

The last week has seen considerable flux in the cost of money. Enthusiasm for cheaper money in the world’s largest economy, the US, helped push global stock markets to new all-time highs. It is four years since global stock markets hit their Covid-19 nadir. Since that point the MCSI World Index – the broadest measure of global share prices – has doubled in value. All this despite rampant inflation, and two globally significant wars.

Dig a little deeper when it comes to the outlook for central bank interest rates, and it is not a simple picture. The path to lower policy rates and lower inflation around the world is far from assured, and certainly not universal. The Bank of Japan – as well as the central banks in Taiwan and Turkey – raised their interest rates last week. By contrast the Swiss National Bank, as well as monetary policymakers in Brazil, Mexico and the Czech Republic went the other way and cut interest rates. These central banks all had one thing in common – they provided little indication of what to expect next. Mixed signals from the real economy are just one of the reasons that central banks have largely dispensed with any forward guidance.

Investors are now asking what all this means for where we are in the economic cycle. I reply to such questions by saying I struggle. With unemployment in almost all major economies at all-time lows, and stock markets at all-time highs – albeit led by a small number of huge companies – then it can look very late cycle. But with household finances improving, Purchasing Manager Indices ticking higher, and semiconductor sales growing at 15% a year it also looks remarkably early cycle. This is the backdrop for central bankers trying to establish the correct price for money. I don’t envy their task.

Sitting at the very heart of these deliberations is the world’s largest central bank, the US Federal Reserve Bank. Last week saw its chair, Jermone Powell, dangling the prospect of a June interest rate cut. But this is not guaranteed amidst a range of economic and political cross currents. Headline US inflation has stalled around three percent for eight months now. This is uncomfortably higher than the Federal Reserve’s two percent price target. However, with a contentious US election honing into view and US credit card debt up 40% in three years – the pressure is mounting for the Fed to provide some relief. One of the remarkable aspects of this year has been that it began with investors expecting six interest rate cuts from the Federal Reserve, this has since been trimmed to three cuts and yet markets truck higher. This has further loosened financial conditions.

Where does this range of international backdrops leave the Bank England in its mission to hit its own inflation target, and to support UK growth? The first thing to recognise is that the UK’s cumulative inflation experience is increasingly looking like that of other major economies. The UK price level may be up a politically-toxic 22% from the start of 2020, but this is not widely different from 20% in the US, and 19% within the Eurozone. Furthermore, with the possibility that UK inflation undershoots its 2% target over the summer these numbers are expected to converge further.     

So for the Bank of England the issues it must address are more nuanced. So elevated was the inflation rate in mid-2023 that any undershoot over the summer – driven by large base effects – may give a misleading picture of how sustainable lower price growth will be. The headlines will put huge pressure on Bank of England to cut its rate from its current 5.25% level, particularly with the prospect of an Autumn General Election. But the most valuable currency central banks have is their credibility. Bank of England credibility will get questioned if they took seven months to raise rates when inflation breached 2% on the way up in 2021 – and immediately respond to an undershoot on the way down in 2024. Looking through volatility in prices in only one direction looks suspiciously like interpreting the inflation target assymetrically. There is no surer way to undermine credibility than approaching an inflation target in this way.

Judging the “run rate” for UK inflation once these huge, energy-driven base effects settle out is a challenge. There is a not insignificant chance that UK inflation picks back up once energy prices stabilise. Whilst we can debate the merits of capping energy prices on incentives for energy efficiency and healthy wholesale markets – there is also the potential cost in making it harder for interest rate setters to make good policy.

There are further delicate issues for the Bank to consider. Next month we will hear from former Federal Reserve chairman, Ben Bernanke, on his review of economic forecasting by the Bank of England. It will be particularly unfortunate if his report coincides with a policy mistake driven by poor data. The Bank of England has, rightly, complained that it is flying rather blind on the labour market given the substandard data provided to it by the Office for National Statistics. If Bernanke – as most expect him to do – cites this as a key impediment, then it will undermine the confidence of the Monetary Policy Committee to move decisively on interest rates whilst these data issues are being resolved.

Finally for the UK, there are big indexation events coming up next week. The National Living Wage is going up 9.8%, the State Pension up 8.5%, and Universal Credit up by 6.7%. There are also a host of commercial contracts like rents, insurance and broadband that are often explicitly tied to the high inflation rate of last year. No-one knows for certain whether a similar indexation event in April 2023 was a contributor to the big spike in UK core inflation that happened around the same time. The risk that history repeats itself is non-zero.

Putting this together – the divergent global backdrop and lots of UK-specific economic noise – getting policy right is a tough task. Whilst June looks the most likely date for the first UK rate cut – where the temptation must be to co-ordinate with the US Federal Reserve and the European Central Bank – this is far from assured. The reputation of the Bank of England as a wise steward of the UK economy is firmly on the line.

Published on The Times 25/03/2024