Central banks are poised to signal interest rate moves in a crucial week

The US Federal Reserve, European Central Bank and Bank of England all are expected to raise interest rates once more this week as they make their first policy announcements for 2023.

Economists will be closely watching policymakers’ rhetoric for clues on the path of future rate hikes this year as the three major central banks try to create a soft landing for their respective economies without allowing inflation to regain momentum.

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All three banks are expected to reiterate their commitment to returning inflation to targets near 2%, but the latest positive data fueled hopes that central banks will eventually be able to slow the pace of rate hikes.

Nick Chatters, fixed income manager at Aegon Asset Management, said the job of market watchers was to “telegraph” from press conferences this week what Fed Chair Jerome Powell and ECB President Christine Lagarde think about the “terminal rate” and how long they intend to keep monetary policy tight before they begin to normalize.

The Federal Open Market Committee wraps up its meeting on Wednesday before the Bank of England and ECB deliver their decisions on Thursday.

Fed

After the FOMC meeting in December, economic data showing softening wage growth and inflationary pressures, along with some more worrisome signals about rising activity, strengthened the case for the Fed to introduce a 0.25 percentage point rate hike – a significant drop from jumbo moves seen in 2022

The the market is now pricing in this casebut the key question is what the FOMC will indicate about further rate hikes in 2023.

“We think the Fed’s path this year is best viewed as a goal to be achieved rather than a target funds rate level to be reached,” Goldman Sachs U.S. Chief Economist David Mericle said in a note on Friday.

“The goal is to continue in 2023 what the FOMC began so successfully in 2022 by keeping the economy on a path of below-potential growth to steadily but carefully rebalance the labor market, which in turn should created conditions for sustainable stabilization of inflation at 2%”.

Fed officials indicated that there is still some way to go before they are confident that inflation will settle at that level. Mericle said a significant “rebalancing of the labor market” would be needed because the gap between jobs and workers is still about 3 million above its pre-pandemic level.

This will force slower growth for a while. Goldman expects a 25-basis-point hike on Wednesday, followed by two additional hikes of the same magnitude in March and May — moves that would push the Fed’s target funds rate to a peak between 5% and 5.25%.

“Fewer increases may be needed if the recent weakening of business confidence captured in the survey data dampens hiring and investment more than we think, displacing further rate hikes,” Mericle said.

“But more increases may be needed if the economy picks up speed again as the drag on growth from previous fiscal and monetary tightening fades.”

Uncertainty about growth rates could cause the Fed to “recalibrate” and end up in a stop-and-go rate pattern later in the year, he suggested.

ECB

The ECB telegraphed a 50 basis point hike for Thursday and promised to stay on course to tackle inflationbut uncertainty remains around the future rate trajectory.

Inflation in the Eurozone fell for the second consecutive month in December, while Tuesday revealed that bloc’s economy unexpectedly expanded 0.1% in the fourth quarter of 2022, curbing recession fears.

The expected half-point increase will raise the ECB’s deposit rate to 2.5%. The Governing Council is also expected to detail plans to reduce its APP (asset purchase program) portfolio by a total of 60 billion euros ($65 billion) between March and June.

In a note on Tuesday, Berenberg predicted the ECB would “likely” confirm its previous guidance for an additional 50 basis point hike in mid-March, followed by further tightening in the second quarter.

The German investment bank stressed that while there were positive signs in headline inflation, firmer core inflation – which reached 5.2% in December – had not yet peaked.

“We expect the ECB to leave open the size and number of its moves in the second quarter. The risks ahead of our call for just one final rate hike of 25 basis points in the second quarter to push deposit rates and prime refinancing rates to peaks of 3.25% and 3.75%, respectively, on May 4 are tilted up,” Berenberg chief economist Holger Schmieding said.

“In line with the ECB’s recent ‘higher for longer’ mantra, ECB President Christine Lagarde is likely to fend off market expectations that the bank will start cutting rates again late this year or early 2024.”

After delaying a rate hike from 75 basis points to 50 basis points in December, the ECB spooked markets by saying that interest rates would have to “rise significantly at a steady pace to reach levels that are sufficiently restrictive.” Schmieding said this sentence will be one to watch on Thursday:

“The ECB is likely to confirm it is moving at a ‘steady pace’ (read: 50 bp in March and possibly beyond) without pre-committing to a 25 or 50 bp move.” in May,” Schmieding said.

“But since interest rates will now be 50 bp. higher than at the ECB’s last press conference, doves may suggest that the ECB should now use a slightly softer term than ‘significant’.”

Bank of England

A key distinction between the Bank of England’s tasks and those of the Fed and the ECB is the persistently bleak outlook for the UK economy.

The bank previously predicted the UK economy was entering its longest recession on record, but GDP unexpectedly rose 0.1% in November after it also beat expectations in October, suggesting the recession may not be as deep as promised.

However, the International Monetary Fund on Monday cut its forecast for UK GDP growth in 2023 to -0.6%, making it the world’s worst-performing major economy, behind even Russia.

Most economists expect a split decision between the Monetary Policy Committee in favor of another 50 basis point increase on Thursday – raising the Bank’s interest rate to 4% – but expect a more dovish tone than in recent meetings.

Barclays expects a split 7-2 vote in favor of one final “strong” increase of 50 basis points, with communications predicting a step down to 25 basis points in March.

“This could be signaled by a removal or softening of the ‘force’ component of forward guidance. Such a tweak would be consistent with our call for two final 25bp hikes in March and May, with the terminal rate reaching 4.5%.” analysts at the British lender said in a note on Friday.

Victoria Clarke, chief UK economist at Santander CIB, expects a far closer 5-4 majority in the MPC in favor of a 50 basis point increase, with the four dissenters split between “no change” and a 25 basis point increase. She said the bank “doesn’t have easy options”.

“Given concerns about the damage that embedded inflation would cause, we believe that the majority of the MPC will consider an increase in the Bank Rate to 4.00% as prudent risk management, but we do not yet believe that it is willing to take bank rate well above that,” Clarke said in a note on Friday.

Santander expects a “double-digit but strong increase” in February and March, and Clarke suggested Governor Andrew Bailey was “optimistic” about falling headline inflation, while becoming increasingly concerned about the outlook for the UK housing market.