26 July 2023
26 July 2023. While the Fed is unanimously expected to hike interest rates by 0.25% this evening and then adopt a cautious, data dependent approach, central bank watchers will have more to digest from tomorrow’s European Central Bank meeting and Friday’s Bank of Japan meeting.
The ECB has already told us that ‘barring a material change to the outlook, we will continue to increase rates in July.’ No surprise, therefore, that every surveyed market participant expects interest rates to rise by 0.25% tomorrow. The Governing Council, however, is concerned about inflation persistence, and is aiming to dampen ‘demand for some time.’ For policy, this means keeping interest rates at levels that are restrictive enough for long enough to slow growth and so bring inflation down. However, there are already signs that policy is working all too well, as Eurozone manufacturing wilts under subdued domestic demand and slow growth in China. Money supply is collapsing, with today’s data release showing M1 falling at an annualised 11% and taking the outstanding stock back to levels last seen two years ago. Nobody should be surprised if the Eurozone were already in recession. Such a backdrop makes the ECB’s forward looking communication difficult, and in the face of a such an obvious slowdown, further hawkishness would seem unnecessary. We therefore expect post-hike communication to be more balanced and would be very surprised if the Governing Council guided for further hikes beyond here. Markets, however, continue to expect another hike in September.
The Bank of Japan also appears to be ignoring what is front of its nose, with signs that the multi-decade disinflationary cycle has finally been broken. Headline Consumer Prices, for example, are growing faster than those in the US and measures of underlying inflation stand at the highest levels seen since the 1990s. Despite this, communication from Tokyo talks about the costs of moving away from Japan’s extraordinary monetary stimulus too early. While it is certainly too early for Japan to change interest rates, we think there is a high probability the BOJ will shift its stance on yield curve control (YCC), a monetary operation that sees the BoJ cap 10-year bond yields. In the medium term, Japan needs a properly functioning bond market and not one where pricing is largely dependent on where the central bank is buying. The BOJ is acutely aware of this effect and monitors it closely. With a new round of economic forecasts, despite dovish talk, it is likely that the BoJ will be forced to revise its medium term inflation outlook higher and this, alongside fears about the side effects of its bond buying, will see it adjust YCC, most likely by widening the band around which it buys, or perhaps shortening the maturity of the bonds. Markets are more sanguine, however, and don’t expect such an adjustment to take place until later this year.