Monetary policy

Fed expected to slow pace of tightening further to a hike of 25bps
The first of the week’s policy announcements will come from the Fed on Wednesday, with the immediate rate decision seemingly straightforward. With policy makers likely to view recent inflation developments as encouraging, our colleagues in Daiwa America – in line with the consensus – expect the majority on the FOMC to favour a further slowing in the pace of tightening, with the FFR target range forecast to rise 25bps to 4.50-4.75%. While some on the Committee might well assess recent improvements in the inflation outlook to warrant a pause in the Fed’s tightening path, our colleagues think the majority will unlikely conclude that policy is insufficiently restrictive to bring inflation back to target. That likely reflects persistent concerns about the tightness in the labour market, especially in the service sector. Indeed, Powell is likely to signal further likely tightening ahead, and re-emphasise that the FOMC thinks that conditions will unlikely warrant a pivot in policy for the remainder of this year.

ECB set to hike by a further 50bps, but signals on the outlook to be closely watched
When the ECB’s Governing Council meeting concludes on Thursday, the immediate interest rate policy decision also seems easy to predict, with another hike of 50bps taking the deposit rate to 2.50%, a level that could reasonably be considered to be restrictive. Meanwhile, the policy statement will probably 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. There is a significant risk that it will again signal the likelihood of further “significant” tightening to come. And President Lagarde might also comment again on the appropriateness (or not) of the current market-implied path of rates. But 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.

This week’s meeting will also see the Governing Council 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 will provide more details 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 is widely expected to raise Bank Rate for the tenth consecutive meeting. But the decision on Thursday 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. Analyst expectations, as well as market-implied pricing, for the pace of tightening this month are split between 25bps and 50bps. That uncertainty reflects the extremely unpredictable economic outlook. And the BoE’s updated projections to be presented this week in its latest Monetary Policy Report (MPR) will play an important role in guiding the policy judgement. The inflation outlook has clearly improved since the Bank’s previous forecasts in November, for which the medium-term projection was already extremely weak and well below target, even assuming no change to rates over the horizon. But despite the slowdown in economic activity, the very tight labour market and accelerating wage growth will remain a concern for the majority of MPC members. Given the labour market, and still relatively high business inflation expectations, on balance, we expect the majority on the Committee to favour a 50bps increase in Bank Rate this week. 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. 

Key data releases

Monday
Ahead of Wednesday’s flash euro area CPI estimate, there was a big upside surprise to this morning’s Spanish data. Contrary to expectations of a big drop, the headline HICP measure saw inflation rise by 0.3ppt to 5.8%Y/Y, a full 1ppt above the consensus. The upwards shift was in part due to petrol and clothing prices, with the latter reflected in a rise of ½ppt in core inflation to 7.5%Y/Y. We suspect the revisions to the inflation basket weights – including increases on energy and food – also played a role. This morning will also bring the first estimate of German GDP for Q4. Full-year data reported growth of 1.9%Y/Y in 2022, which assuming unrevised output in previous quarters could imply that the euro area’s largest member state avoided a contraction in the final month. Our baseline expectation is for a modest drop (-0.1%Q/Q). Meanwhile, the European Commission’s business and consumer surveys are likely to report a modest improvement in conditions at the start of the year consistent with the results of the flash PMIs.

Tuesday
A busy day for top-tier releases kicks off with the usual month-end tranche of Japanese data, including IP, retail sales and labour market figures for December and consumer confidence for January. The first estimate of euro area Q4 GDP is likely to confirm a further slowing in economic activity in the final quarter of last year. We expect a modest contraction in the euro area (-0.1%Q/Q). Meanwhile, flash estimates of German and French inflation for January will also be closely watched and expected to report a pickup. In the US, the employment cost index – arguably the best measure of labour compensation – will be key, with a notable cooling in Q4 likely to ease the Fed’s concern about labour costs and service prices.

Wednesday
A key release on Wednesday will be the flash euro area inflation estimate for January. The headline HICP inflation rate had been expected to ease for a third consecutive month, with the Bloomberg survey consensus for a drop of 0.2ppt to 9.0%Y/Y. But the upside surprise in today’s Spanish numbers certainly raises the significant risk of a higher than expected print this month, with the possibility that core inflation rose to a new record high from 5.2%Y/Y in December too. Of course, as illustrated by the Spanish figures, there is a very large degree of uncertainty with respect to these forecasts, not least as the inflation basket weights will be revised. Euro area unemployment figures for December are also due, along with the UK Nationwide house price survey. The US manufacturing ISM survey is likely to remain consistent with ongoing contraction in the sector.

Friday
All eyes on Friday will be on the US payrolls number. While initial jobless claims have remained relatively low, cautious hiring is likely to leave net job growth below the average of 261k in the prior five months – our colleagues at Daiwa America forecast an increase of 190k (marginally above the Bloomberg survey consensus of 185k). The January report will include benchmark revisions to the payroll data. A preliminary estimate released in August indicated an upward adjustment of 462k to the level of employment in the benchmark month (March 2022; 0.3% of total employment). The report also will include new population controls for the household survey, although these will not be applied to prior data, which could distort comparisons with pre-2023 figures. The US services ISM is expected to report a further slowing in activity at the start of the year. Final services and composite PMIs from Japan & Europe are also due, along with euro area PPI figures.