For something that cannot be directly observed, and changes through time, the neutral level of interest rates generates an awful lot of debate, says Strategist Russell Silberston.
20 Feb 2023
20 February 2023, In a recent radio interview, Huw Pill, Chief Economist at the Bank of England, talked about the need for a ‘zen-like balance in our objective.’ For an institution whose mission statement is ‘Promoting the good of the people of the United Kingdom by maintaining monetary and financial stability’ this reference to Buddhism seems somewhat unusual - particularly for a central banker facing 10% inflation. However, a casual internet trawl of Zen’s meaning talks of self-restraint, meditation, and insight into the nature of things. This implies that Pill is hoping he and fellow policy makers can reach monetary enlightenment by raising interest rates just enough to return inflation to target without pushing the economy into a deep recession. This is despite the huge uncertainty the post-Covid economy presents.
While the BoE is unlikely to win awards for straight-forward communication, its stance is similar to other major Western central banks that are grappling with the same problem: labour markets remain hot, despite the largest rate hiking cycle in a generation, and inflation, while turning lower, is being driven down by international goods prices rather than domestically set service prices. No central banker wants to drive their economy into the ground but equally, they can’t be seen to fail to tackle inflation. The Holy Grail, therefore, is the economic soft landing.
Striking this delicate balance explains why we are at the point where a pause in rate hikes is on the horizon. In the United States, in an over-looked section of the recent FOMC press conference, Chair Powell noted that he and his colleagues were ‘talking quite a bit about the path forward’. He added that the minutes, when released, will provide ‘a lot of detail’. Similarly, the European Central Bank pre-announced a further 0.5% rate increase next month. But then Christine Lagarde, ECB President, added that ‘we will then evaluate the subsequent path of our monetary policy.’
Unfortunately, history is not on the side of those hoping for an economic soft landing. Professor Alan Blinder, former vice chair of the Federal Reserve reviewed soft and hard landings in the US1 over the past 60 years. Of the 11 interest rate cycles identified, just three ended in a soft landing, an outcome defined as no cumulative fall in GDP. Each rate cycle was of vastly different magnitudes and duration, but on average, benchmark Fed Funds were raised by 525 basis points including the two epic 1000bp plus cycles between 1977 and 1981. For those holding onto the soft landing narrative, it should be noted that the three cycles Blinder labelled as soft, saw a cumulative rate increase of just 266bps. With recent Fed communication suggesting we have one or two more hikes to go, this cycle is going to see cumulative hikes of 525bps, exactly in line with the historic average. It should be no surprise, therefore, that after such aggressive monetary action, the Fed, along with its Western peers, is rapidly approaching an inflection point.
A brief look at economic history tells us what happens when we get to the end of a hiking cycle. Over Blinder’s 11 historic examples, just six months after the last hike, rates were 160bps lower on average. However, this data is distorted by the actions of Chairman Burns, who cut rates by nearly 6% in the mid-1970s, only to see inflation accelerate and become embedded in the economy. It was only the drastic actions of his successor Paul Volcker that set the disinflationary process into motion, but at huge economic cost. More recently, the four cycles dating back to 1993 have seen an average reduction of just 18bps six months after the last hike. No US central banker wants to be associated with Burns, so expect a long period of stable rates once we peak in the first half of 2023.
If a soft landing after an aggressive hiking cycle would be an economic first, what are the alternatives? History is on the side of the hard landing, although globally this is not going to happen unless labour markets soften. However, this still seems the most likely scenario despite the recent stellar US jobs report. The other scenario, which we believe is now marginally more likely than a soft landing, is the ‘no landing.’ In other words, economic growth remains resilient despite the rate increases, but with labour markets remaining tight, central banks conclude that disinflation may be temporary and tightening therefore needs to resume.
Perhaps Pill is correct to channel his inner Zen; central banks have an incredibly difficult task ahead, as history shows. The rate hiking cycle of the past year is getting to the point where policy makers will pause and reflect on their actions so far. What happens thereafter is difficult to predict, but the two most likely scenarios are not supportive of risk assets.