All eyes turn to the ECB and BoE

Chris Scicluna
Emily Nicol

ECB set to hike rates by 50bps today, but signals on the outlook to be closely watched
Today’s immediate ECB interest rate policy decision is easy to predict, with another hike of 50bps set to take the deposit rate to 2.50%, which will take the cumulative tightening since July to a hefty 300bps and a level that could reasonably be considered to be restrictive. The policy statement will also repeat that “future policy rate decisions will continue to be data-dependent and follow a meeting-by-meeting approach”. Apart from that, however, the Council’s updated forward policy guidance, which will have an important bearing on the market mood, is uncertain.

In our view, the Governing Council would be wise this month not to pre-commit to a particular path of tightening before considering the updated economic projections due in March. GDP was firmer than feared in Q4, rising 0.1%Q/Q compared to the ECB’s baseline forecast of -0.2%Q/Q. The labour market still appears tight too. However, growth in Q4 was more than fully explained by multinational corporations based in Ireland for tax purposes, and underlying economic activity is likely to have been much softer – indeed, the end of the year appears to have been particularly weak as evidenced by the sharp drop in German retail sales, as well today’s dreadful German trade report, which recorded the steepest monthly drop in the value of exports (-6.3%M/M) and imports (-6.1%M/M) since January 2009 (when excluding the initial pandemic slump in March/April 2020).

In addition, while the full impact of recent tightening has yet to be fully felt, the latest ECB’s credit conditions survey results reported the most stringent net tightening in standards on loans to non-financial corporations since the euro crisis in 2011 as well as falling demand for loans by firms and households. Moreover, the significant drop in wholesale gas prices to well below levels a year ago, as well as a cooling of global goods inflation and shipping costs, the associated reduction in supply-chain challenges, and ongoing strengthening of the euro exchange rate, all means that the inflation outlook has improved since the December meeting. Indeed, yesterday’s downside surprise to headline euro area inflation raises the possibility that inflation could fall back to target by the end of this year, and certainly well before the ECB’s December baseline projection that it will not reach that point before Q325.

However, while some of the doves on the Governing Council (such as Executive Board member Panetta and Bank of Italy Governor Visco) have argued that the ECB should avoid prejudging the appropriate policy decision in March, last week also some of the typically more balanced members of the Governing Council (such as Irish Governor Makhlouf) support the hawks in signalling their desire for a further 50bps hike in March. So, we see a significant risk that today will similarly signal the likelihood of further “significant” tightening to come at the end of the quarter and perhaps beyond. And President Lagarde might also comment again on the appropriateness (or not) of the current market-implied path of rates.

Aside from the decision and updated guidance on rates, the Governing Council will provide more detail on how, from March, it plans to reduce its portfolio holdings under its regular Asset Purchase Programme (APP). We already know from the last policy announcement that the APP portfolio will shrink by €15bn per month on average until the end of Q2. The ECB should provide information related to the future composition of the portfolio, including with respect to the balance between various asset classes, and plans to “green” the remaining bond holdings. Among other things, the ECB’s portfolio of private sector securities might be unwound at a faster pace than its holdings of government bonds. At the same time, however, an excessively rigid or aggressive plan to unwind government bonds might pose a particular risk to periphery government bond prices.

BoE decision finely balanced as MPC weighs up strong wage growth but contracting economy
The BoE’s MPC is widely expected to raise Bank Rate for the tenth consecutive meeting. But the decision is likely again to be split at least three ways, with external members Silvana Tenreyro and Swati Dhingra likely to vote once again for no change to policy. And the size of the rate hike is difficult to predict with confidence. The BoE’s updated projections in its latest Monetary Policy Report (MPR) will play an important role in guiding the policy judgement. Overall, given the tight labour market, still relatively high business inflation expectations, and a likely pessimistic revision by the Bank to its estimates of the equilibrium unemployment rate, potential growth and spare capacity, we expect the majority on the Committee to favour a 50bps increase in Bank Rate. But we also recognise the non-negligible risk of a smaller hike. And while the Bank might well signal the likelihood of some additional tightening ahead, the forward guidance might be more equivocal than before.

Encouragingly, GDP in Q4 appears to have been a little more resilient than feared in November, albeit likely still down modestly from Q3. But the very tight labour market will remain a concern for the majority of MPC members. Indeed, the acceleration in wage growth in the three months to November (6.4%3M/Y), and jump in services inflation in December (6.8%Y/Y), will continue to stoke fears of second-round effects on future prices. Nevertheless, headline inflation in Q4 (10.7%Y/Y) came in a touch softer than the Bank’s previous forecast (10.9%Y/Y). And BoE staff estimated in December that the revised Energy Price Guarantee would reduce the forecast for inflation in Q2 by ¾ppt. Since then we have also seen a further marked decline in wholesale natural gas prices, which in the fifteen-day period used to set the respective assumption in the BoE’s February forecasts were more than 60% lower than in the equivalent period before the November MPR.

Reflecting the developments in energy markets, Governor Bailey suggested last week that inflation is now on track to fall rapidly from the spring as supply-side pressures recede. Indeed, the BoE’s November forecast for 2024-25 was already extremely weak, with headline CPI expected to fall below 1%Y/Y at the end of the horizon even in the event that Bank Rate had been unchanged at 3.00%. Of course, this weakness also reflected the Bank’s expectation that demand would fall steadily due to the record decline in household real disposable incomes. But while the anticipated downturn over the coming quarters might not be as deep as the November MPR baseline forecast suggested, recent indicators – including the flash January PMIs and ongoing deterioration in housing market conditions – suggest that economic activity weakened at the start of the year. And recession through the first half of 2023, if not beyond, will likely remain in the BoE’s baseline projection.

BoJ’s JGB holdings rise by a record amount in January as it defends its YCC framework
In Japan, the central bank’s monthly accounts data for end-January today confirmed that the BoJ had to conduct record amounts of bond-buying at the start of the year to defend its YCC framework. Indeed, the outstanding amount of JGBs on its balance sheet rose by ¥20.3trn in January, almost double the previous record increase in October. As such, over the past three months the BoJ has now increased its JGB holdings by ¥29trn.

Powell sounds more equivocal about outlook, fails to shift expectations of a pivot this year
As expected the FOMC slowed the pace of its rate hikes yesterday to 25bps, taking the target range for the Fed Funds Rate to 4.5-4.75%. And as evident from the reaction of USTs, with yields down about 10bps across the curve, Jay Powell and the FOMC failed to buck market expectations that the end is in sight for the Fed’s tightening cycle. Admittedly, the FOMC’s statement went through the motions again, repeating that “The Committee anticipates that ongoing increases in the target range will be appropriate”. However, an amendment to its signal on future hikes – referring to their “extent” rather than the “pace” – hinted that the finishing line might be approaching. The statement also acknowledged that inflation “has eased somewhat”. And in his press conference, Powell kicked off by judging that “the disinflation process has started”.

Of course, Powell also insisted in his press conference that he saw no grounds for complacency. He also flagged worries about persistence in non-housing core services inflation, and made it clear that the Fed would respond to strong data if required. But he added that monetary policy works with a lag, so the past year’s hikes would help to restrain inflation for a while to come. And also acknowledging the notable improvement in the recent dataflow, Powell failed to insist that the Fed’s December dot-plot, which saw the FFR above 5% at end-2023, was still the best guide to the most likely path for policy. Instead, he suggested that the FOMC’s updated projections due late next month – after the release of two more monthly CPI reports – would inform everyone whether market pricing looked consistent with the FOMC’s outlook or not. So, while our colleagues in Daiwa America still don’t think the Fed will pivot before year-end, Fed Funds Futures continue to price such a shift.

US job cuts and jobless claims figures due alongside Q4 productivity data
Ahead of tomorrow’s US payrolls report, today will bring the latest Challenger job cuts figures for January, weekly jobless claims numbers for the final week of last month, as well as productivity and labour cost data for Q4.

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