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Navigating the path back to normal

As central banks in advanced economies begin to tighten policy, two questions hang over financial markets: how quickly will policymakers increase interest rates and how far might rates ultimately need to rise?

Our job is to help our clients navigate economic and markets uncertainty – and conditions haven’t often looked so uncertain. The dislocation caused by the pandemic – and the unprecedented response to it by policymakers – has repeatedly challenged assumptions and wrong-footed investors. Forecasters are therefore obliged to modify the confidence with which they make their prognostications.

With that said, one thing I think we can be reasonably sure about is that we’re at the point where the pressure on central banks to act is at its greatest. Inflation has either further to rise or, where it has peaked, won’t show a clear downward trend for a few months. Shortages are still acute. And political pressure to tackle the “cost of living crisis” is high. 

At the same time, central banks have also been later to start tightening than is typically the case. The usual approach is to begin tightening once the recovery is established with the aim of getting policy back to a neutral setting by the time the economy returns to full employment. This time, scarred by the experience of persistent inflation undershoots in the wake of the 2008 financial crisis, central banks have bided their time. 

Judging the amount of slack in today’s labour market is difficult, but most measures point to there being considerably less than is usually the case when central banks begin to raise interest rates: unemployment is lower than at the start of recent cycles (although this is partly for structural reasons), and wage growth is higher. Both headline and core inflation are higher too. (See Table 1.)

Table 1: Recent monetary policy tightening cycles

Sources: Refinitiv, Capital Economics

All of this could justify a faster pace of tightening in the early stages of this cycle as policymakers play catch-up. If this happens, it is perhaps more likely to come in the form of 25bp rate increases at consecutive meetings, rather than larger (50bp+) increases that could be construed as panic. With the exception of the ECB’s first hike at the inception of the euro, every tightening cycle by one of the world’s major advanced economy central banks since the mid-1990s has started with a 25bp increase. But in the current climate we wouldn’t rule anything out. 

The key point is that the initial pace of tightening won’t set the tone for the whole cycle. Even if policymakers do tighten more aggressively at the start, the pace of tightening should moderate by the end of this year as inflation drops back and the pressure on central banks starts to ease. 

This brings us to the question of how far interest rates will ultimately rise. The uncertainties here are even greater. We’ll have more say about this in a forthcoming series of work, but four points are worth keeping in mind. 

First, inflation is likely to fall over the course of this year as energy and goods inflation ease, and the immediate inflationary effects of the pandemic fade. 

Second, while “excess demand” will remain a concern in some economies over the next six to 12 months, this should start to ease next year as supply constraints and reopening frictions diminish. 

Third, to the extent that it remains a helpful concept, the neutral real interest rate is still relatively low in most economies. Accordingly, it will not require much in the way of tightening to cause policy settings to become restrictive. 

Finally, what really matters is how monetary tightening affects financial conditions in the real economy. The transmission mechanism from monetary policy to financial conditions is murky and subject to forces that can change in unanticipated ways between cycles. The Fed raised policy rates by 425bps in the cycle that started in 2004 yet financial conditions loosened as the global savings glut forced down long-dated Treasury yields. (See Chart 1.) In contrast, the Fed raised interest rates by 225bps in the cycle that began in 2015 and financial conditions tightened considerably. The tools available to central banks are less precise than is often assumed.  

Chart 1: Capital Economics US Financial Conditions Indicator

Sources: Refinitiv, Capital Economics

A key consideration in this cycle will be how Quantitative Tightening, or QT, affects financial conditions. By its very nature, this is a relatively new addition to the policy toolkit so there is little historical evidence to draw on. But it’s possible that QT could become an important part of the toolkit, particularly given the potential for it to drive up term premia in government bond markets from current low levels, and therefore increase yields at the long end of the curve. Viewed this way, QT may be used more extensively in economies where central banks are particularly concerned about the potential inversion of yield curves (notably the US). In contrast, the ECB may adopt the opposite position – maintaining a larger balance sheet and higher sovereign bond holdings to limit fragmentation risks in the euro-zone.

Either way, the point is that changes to interest rates are not the only game in town. When thinking about how much monetary policy will need to tighten, we need to consider how rate increases interact with QT, and how both subsequently impact overall financial conditions. 

Given the uncertain outlook, the best approach for central banks is to start getting policy settings closer to a more neutral setting and then to assess how macro and market conditions are responding. In the US and UK, that probably means raising interest rates to a range of 2-3%, rather than to 5% or more as some inflation hawks have called for. In the euro-zone, it means getting policy rates into positive territory while trying to limit an expansion in German-Italian bond spreads. And in Canada, Australia, and New Zealand it means getting policy rates back to 2% and trying to achieve a soft landing in housing markets. In some countries – notably the US and UK – there may be a case for front-loading tightening.

Although central bankers are having to take different policy paths, inflation’s resurgence means their direction of travel is the same. These uncertain times mean they’ll have to tread carefully.

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