Stephen Miller

At its recent meeting, the US Federal Reserve’s (Fed) Federal Open Markets Committee (FOMC) opted to “skip” a hike in the policy rate. However, the Fed indicated that more policy rate hikes may be in the offing, implying some ongoing anxiety at the pace at which inflation is falling.

This suggests that in the Fed’s view the policy rate is best considered as approaching (or at) a “plateau” rather than a “peak”. That is consistent with recent Fed communication indicating the policy rate will stay “high for longer”.

That is the case despite a revision downwards in the median core personal consumption expenditures (PCE) price index measure in 2023. The Fed now expects inflation, as measured by that index, to be 3.7 per cent by end-2023 (from 3.9 per cent projected in June), falling to 2.6 per cent by end-2024 (unchanged from the June projection).

Those projections, however, reflect no change in the assumed terminal policy rate at the end of 2023 (the median “dot plot” projects a policy rate of 5.6 per cent by end-2023, unchanged from the June projection). However, in a powerful reinforcement of the “high for longer” mantra, the assumed policy rate for end-2024 has been revised upwards to 5.1 per cent (from the 4.6 per cent in projected in June).

Last week’s August consumer price index (CPI) was consistent with ongoing disinflation, albeit that progress on services inflation remains grudging.

Reflecting better than anticipated outcomes so far in calendar 2023, gross domestic product (GDP) growth for 2023 and 2024 was revised upwards to 2.1 per cent in 2023 and 1.5 per cent in 2024 from the 1.0 per cent and 1.1 per cent respectively that was projected in June. The unemployment rate for end-2023 and end-2024 were revised down to 3.8 per cent (from 4.1 per cent projected in June) and 4.1 per cent (from 4.5 per cent projected in June) respectively.

Curiously, Bloomberg reports Fed Chair Powell as saying a “soft landing” is not the Fed’s baseline expectation for the US economy, but it is the primary objective as it seeks to contain inflation. Yet the median projections epitomise what a soft landing would look like.

But inflation (particularly “sticky” services inflation) remains the key focus.

In his press conference, Chairman Powell continued to emphasise the inflation challenge, indicating that the Fed was “prepared to raise rates further if appropriate and we intend to hold policy at a restrictive level until we’re confident that inflation is moving down sustainably toward our objective.”

However, in a concession to ongoing uncertainties with respect to economic conditions, and a nod to the lags with which monetary policy operates, the Fed Statement Powell noted that the Fed will “proceed carefully” as it assesses incoming data and the evolving outlook and risks. He added that after raising rates rapidly in the last year or so “we’re fairly close we think to where we need to get.”

The Fed’s retention of its “hawkish” disposition may in some measure be a device to forestall a further easing in financial conditions. The US bond market has consistently under-estimated how high the Fed would take the policy rate and how far the Fed is from contemplating any cut in the policy rate. Markets have more recently tempered their difference of view with the Fed, and it may be that the Fed was concerned not to excite too much market exuberance to a policy rate “skip”, hence the attachment of a “hawkish” rider.

My view is that the Fed’s progress on inflation is probably tracking at a marginally faster pace than embodied in the median projections.

Financial markets reacted to the “plateau” not a “peak” message by taking bond yields higher in bear flattening mode. However, given what are slivers of good news on inflation (services “stickiness” notwithstanding), it is not a stretch to posit that government bonds offer investors a modestly attractive enough yield without the prospect of significant capital losses.

In my view, the current level of US bond yields argues for a strategic neutral (from underweight) positioning in bonds in a multi-asset portfolio.

There are upside risks in the form of unanchored inflation expectations, but they are arguably symmetric with downside risks associated with a sharper than anticipated slowdown.

The prevailing level of US bond yields opens the way for the Fed to respond to a crisis enabling bonds to potentially re-assume their sometime role as a mitigant to risk-averse sentiment.

It has been sometime since bonds were able to deliver these diversifying qualities to portfolios. And it is these diversifying qualities (along with reasonable yields) that are the most attractive element of bonds in a portfolio, not the prospect of significant capital gains.

At a minimum, the Fed is close to the completion of the tightening cycle without there yet being evident any extreme dislocation in activity or employment that had been feared at various times by financial markets. At some stage, and despite Powell’s comments that a “soft landing” is not the Fed’s baseline expectation, markets may romance further the possibility of more optimistic outcomes involving the Fed successfully “threading the needle” and engineering a relatively benign disinflation without an excessive dislocation in activity and employment.

That benign scenario rarely happens, but…?

Coming up: Bank of England to raise the policy rate 25 bps at tonight’s meeting – no change (yet) from the Bank of Japan

Bank of England: Modest CPI cast doubt on policy rate hike at tonight’s meeting.

Perhaps the Bank of England (BoE) can dare to think that they might finally be getting on top of inflation with the release overnight of considerably better than expected August UK CPI figures.

Headline inflation fell to 6.7 per cent from 6.8 per cent in July and an expected 7.0 per cent. On a core basis annual inflation fell to 6.2 per cent from 6.9 per cent in July and was markedly better than the expected 6.8 per cent.

UK gilts rallied and sterling slipped sharply in the wake of the release as markets pared back expectations that the BoE would proceed with a policy rate hike when it meets tonight.

Earlier in the week, markets had priced the eventuality of a further hike at that meeting as a near certainty. That has now been reduced to somewhere closer to 50 per cent.

As encouraging as these numbers are, I suspect that they will not be sufficient to prevent a further 25 basis point hike when the BoE meets tonight. That will take the policy rate to 5.5 per cent.

For one thing there have been “false dawns” in the past both in the UK and elsewhere, including earlier this week in Canada. And while not necessarily dismissing these numbers as a “false dawn”, the “stickiness” in inflation worldwide will mean that at least one more increase of an “insurance” nature is warranted.

Indeed, the UK economy exhibits some characteristics that suggest a greater inflation proclivity. These include:

• Stronger worker resistance to real wage erosion. These were in evident in the July wage numbers released last week showing strong wage growth (8.5 per cent including bonus; 7.8 per cent ex-bonus).
• Ongoing disruptions to external trading relations post-Brexit that have slowed supply chains and a lower degree of internal economic flexibility leading to productivity challenges.
• Limited government effort toward supply-side enhancement.

The latter two points were in large measure a consequence of the mismanagement of Brexit occasioned by a distracted (even indolent) Johnson Government and the turmoil wrought by the fleeting Truss Government.

The BoE was also complicit in the UK’s relatively poor inflation performance. Throughout 2022 it exhibited not a small amount of prevarication in assuming a frontline role in fighting inflation. However, in 2023 it has adopted a more forthright stance and last night’s better than expected August CPI report may be a harbinger of the benefits of that approach.

On that basis, I expect that any announcement of a policy rate hike will be couched in communication that gives the BoE optionality going forward by indicating that rather than any ongoing tightening disposition, the BoE is now in “wait and see” mode, albeit sating that the option of further increases remain on the table should that be warranted.

Bank of Japan: No change…yet!

The Bank of Japan (BoJ) has a history of delivering surprises. On Christmas Day 1989 the BoJ raised the policy rate to address concerns around a weakening yen. And just before Christmas last year the BoJ increased the cap on ten-year government-bond yields from 0.25 per cent to 0.5 per cent. That caused a surge in the value of the yen.

Since that time under a new Governor in Kazuo Ueda, who took the reins in April, the Bank has retained the policy (overnight cash) rate target at -0.10 per cent and has had a notional target for the 10-year JGB at 0 per cent, albeit within a target range of +/- 0.5 per cent with an upwardly moved “cap” of 1.00 per cent instituted in July. At the time of writing the 10-year JGB yield was 0.72 per cent.

No change is expected at Friday’s meeting – for one thing Christmas is still 3 months away.

In comments earlier this month, Governor Ueda said the BoJ may have enough data by year-end to determine whether to end negative rates. Crucial in that regard is whether wage and price data might indicate that Japanese inflation can be credibly sustained at the BoJ’s 2 per cent target. It is currently a little above 3 per cent.

Financial markets are increasingly of the view that such a judgement might well be made by year-end (Christmas?) or early in 2024. That would result in the end of a negative policy rate in Japan.

However, markets are unanimous that no such shift on policy will occur at Friday’s meeting.

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