Central Banks Align on ‘Restrictive for Longer’ Policy Position

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Eurozone Market Update

With no ECB monetary policy meeting in August, investors’ focus turned to the euro area’s key economic data releases. Second quarter GDP grew 0.3%, beating expectations of 0.2%. August’s unemployment rate of 6.4% came in 0.1% lower than expected. Crucially, the euro area composite Purchasing Managers Index (PMI) of 47.0 fell well below expectations of 48.5 (see Chart of the Month). The services PMI fell particularly sharply to 48.3 versus expectations of 50.5. German PMI came in 3.6 below market expectations. Expectations for euro inflation over the next 12 months soften to 3.4% for June, according to the monthly ECB survey, compared to May’s 3.9% forecast. Markets are split over a 10th successive interest rate hike at September’s ECB meeting.

Euro Short Term Rates

_{Source: Bloomberg, data as of 31 August 2023}

UK Market Update

The BoE increased the bank rate by 25 bps to 5.25%. The bank included new guidance that it “will ensure that the bank rate is sufficiently restrictive for sufficiently long to return inflation to the 2% target sustainably in the medium-term.” Governor Andrew Bailey stated there are different paths available to reach the inflation target, which suggests to us that options include a higher peak rate and faster cuts or a lower peak rate for a prolonged period. Updated BoE projections estimate inflation will return to 2% by mid-2025. Higher rates appear to be slowing the economy, as the PMI composite of 47.9 missed expectations of 50.4. However, we think the continued wage surge of 8.2% has kept inflation elevated. Inflation of 6.8% was down but still higher than anticipated, while core inflation, which excludes more volatile food and energy prices, was higher at 6.9%.

US Market Update

At August’s Jackson Hole symposium, Fed Chair Jerome Powell underscored the Fed’s commitment to data dependence. However, there was no suggestion that signs of economic resilience have prompted Fed officials to revise their rate outlook. Although Powell was not ready to declare victory on inflation (noting recent softer inflation reports were “only the beginning of what it will take”), he also did not appear willing to suggest that the ongoing resilience of economic growth may necessarily prompt further tightening. The minutes of the Fed’s late July meeting suggest no rush for another 25 bps hike in September, noting “it was important that the [Fed’s] decisions balance the risk of an inadvertent overtightening of policy against the cost of an insufficient tightening.”

USD Short Term Rates

_{Source: Bloomberg, data as of 31 August 2023}

Looking Ahead

The Fed explicitly left the door open for further tightening, but they also see signs of inflation pressures potentially abating. Markets may be underappreciating the chances for further policy tightening followed by an extended hold rather than a quick reversal to cut rates. The ECB has entered a new phase where both hikes or skips are possible. We remain confident that inflation is getting closer to the ECB’s terminal rate, but the strength of labour markets continues to pose upside risks. The BoE’s decision to step down the pace of hikes while continuing to highlight various upside risks came as a surprise. We believe the BoE is biding its time to allow lagged economic impacts of prior tightening to filter through to the economy while avoiding breaking the housing market. The message from the Fed, ECB and BoE remains clear: They are data dependent and monetary policy will likely remain restrictive for longer than the market is pricing.

Chart of the Month: Drop in Service Sector Activity Flags Recession Risk in the UK and Eurozone

_{Source: Bloomberg as of 31 August 2023}

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