No One Wants a Recession, but Central Banks are willing to Take the Risk to Demonstrate Anti-Inflation Resolve

The week ahead is busy. Three G7 central banks meet, the Federal Reserve, the Bank of Japan, and the Bank of England. In addition, Japan and Canada report their latest CPI readings, and the flash September PMI are released.  

There are three elements of the Fed's meeting that are worth previewing. First is the interest rate decision itself and the accompanying statement. Ironically, this seems to be the most straightforward. Even before the August CPI surprise, the Fed funds futures market was confident of another, the third, 75 bp increase. The labor market's strength gives the Fed confidence that the economy can still handle the expeditious attempt to bring inflation back to target. The statement itself need not change very much. It may recognize the weakening of the housing market or signs that sub-trend growth is likely to be extended. Both would be consistent with tightening financial conditions and efforts to ease price pressures.  

Second is the new Summary of Economic Projections, the dot plot. The dots that get the most attention are the ones for the Fed funds target. The median Fed forecast was for 3.375% Fed funds rate for the end of this year. This will likely be put higher in the new iteration. Fed funds futures market is between 4.0% and 4.25%. For next year, the median dot was 3.75% and back down to 3.375% in 2024. Here is where the communication has broken down: the market has the Fed funds peaking between 4.25% and 4.50% in Q1 23. However, despite official attempts to push against it, the market looks for a cut next year. The implied yield of the December 2023 Fed funds futures contract is about 35 bp below the implied yield of the March 2023 contract.  

Using Bloomberg's median results of its survey as representative of the market, it is worthwhile comparing it with the Fed's macroeconomic projections. On GDP, the market median for this year and the Fed's are almost identical at 1.6% and 1.7%, respectively. However, the median economist forecast for next year is 0.9%, nearly half the Fed's June median of 1.7%. Both expected growth to recover in 2024, but the market is less sanguine than the Fed at 1.6% vs. 1.9%. 

The median economist forecast is for more inflation and higher unemployment than the Fed's median projection in June. They concur with this year's unemployment rate at 3.7%, but while the median Fed dot is for 3.9% next year and 4.1% in 2024, the median economist forecast is for 4.1% and 4.3%, respectively. While the market and the Fed have inflation near 2.0% in 2024 (2.1% and 2.2%, respectively), how they get there is a different story. The median forecast for the PCE deflator is 6.1%, while the June dot was at 5.2%. Next year, the median economist forecast sees inflation slowing to 3.3%, while the median dot in June was at 2.6%. We suspect that the pain Fed Chair Powell cited will translate to the median dot being lower for 2023 growth and raised for 2023 and 2024 unemployment.  

The third component of the FOMC meeting is Powell's press conference. A change in the market's reaction function became evident with the Chair's brief speech at Jackson Hole. Until then, it seemed that the market was bent on reading him dovish even as the Fed showed it had engaged in one of the most aggressive tightening operations in its history. Several times this year, the market reacted as one would expect as rates were hiked and then abruptly changed directions as the Chair spoke. Still, Powell has a particularly fine line to walk. He wants to show that the central bank is attentive to the near-term downside risks to the economy while still seeing the entrenchment of higher inflation expectations as the greater risk. The market has nearly another 75 bp discounted for the following meeting in early November. There is no need for him to push against this besides saying something non-committal, like a 50 or 75 bp hike may still be appropriate.   

The Bank of Japan meeting ends early on September 22, and the Bank of England meeting a few hours later. Japan will report August inflation figures a few days before the BOJ meeting. The Tokyo CPI does a good job anticipating the national figures. Indeed, the median forecast in Bloomberg's survey for the national CPI matches the results of the Tokyo report. Headline CPI is seen rising to 2.9% from 2.6%. The core measure, which excludes fresh food, is seen increasing to 2.6% from 2.4%. Excluding fresh food and energy, Japan's CPI may rise to 1.4% from 1.2%.  

While BOJ policy is widely criticized. Many intimate that it is simply Governor Kuroda's doing. This seems to miss a key point. The market also expects Japanese inflation to prove transitory. First, consider the forecasts.   The Bank of Japan's forecast for core CPI, which it targets, is at 2.3% this year, 1.4% next, and 1.3% in 2024. The median forecast in Bloomberg's survey is for core inflation to be 1.8% this year, 1.4% next, and 0.9% in 2024. Second, what about breakeven rates? The 5-year breakeven is 1.16%; beyond that, the readings for 6-10 years are between 0.85% and 0.95%.  

There is little for the BOJ to do outside of cautioning the market against rapid moves in the foreign exchange market. One of the benefits of floating exchange rates, which before the end of Bretton Woods collapsed, was a historical anomaly, is that it allows for nearly constant but incremental changes. Pegged regimes offer periods of stasis but are followed by dramatic moves that frequently were destabilizing. So it is understandable why Japanese officials may feel frustrated with the "excess" volatility, which the G7 and G20 have also warned against.  

Still, many find it difficult to be too sympathetic to Japan, though it is ironic that the yen is being punished partly because Tokyo has achieved what has proven so elusive for others: price stability. The yen is not the most volatile of the major currencies. Looking at benchmark three-month implied volatility, that dubious honor goes to Sweden and Norway. Nevertheless, much ink has been spilled, calling attention to the yen being at its lowest since 1998. Yet, sterling which reached its lowest level since 1985, got a fraction of the press.  

The Bank of England has lifted rates six times beginning last December and, like the comedian Rodney Dangerfield, gets no respect. It is one of the weakest major currencies this year, off around 14.7%. Only the yen (~-20%) and the Swedish krona (~-14.8%) are down more. Due to the Queen's memorial, the Bank of England meeting was postponed a week.  

The issue now is whether the Bank of England hikes 50 bp or steps up to 75 bp.    The swaps market had seen around an 80% chance of the larger move, but by the end of last week and the unexpectedly poor retail sales report, the market is more comfortable with a 59 bp increase. A half-point move would lift the bank rate to 2.25%, a little above the upper-end of the range associated with neutrality. The market sees a terminal rate of near 4.50% in Q2 23. It has risen by about 100 bp since mid-August.

Many participants are thinking through the implications of the new government's fiscal plans. It is arguably too early to take it into account. The plans have yet to be formally presented. Some of what is seen as government borrowing now may be offered as guarantees for lending or liquidity provisions. Still, the trajectory of the policy mix, more expansionary fiscal policy, and tighter monetary policy tends to support the respective currency. However, we suspect this could be more salient after the dollar turns, and in the short-run, offset by the likely deterioration of the current account deficit, which is the largest among the major economies, projected to be almost 6% of GDP this year.  

A secondary issue that the MPC is to vote on is the plans to sell GBP10 bln of bonds a quarter to expedite the pace that the balance sheet is unwound. This is in addition to the more passive course of refraining from recycling the full amount of maturing issues. The challenge now is that the new government may boost borrowing by as much as GBP200 bln. Some increase was likely, but this is probably considerably more than anticipated when the Tory leadership contest began.  

Dynamic accounting allows for some of that increased spending to find its way back into the government coffers via stimulating spending and profits. Usually, the fiscal initiative would be evaluated by an independent body, like the Office of Budget Responsibility, established in 2010, but Prime Minister Truss reportedly will sidestep this process. The Chancellor of the Exchequer Kwarteng will set out the government's plans and costs in a fiscal statement later this month.

The flash PMI start the new monthly cycle of high-frequency data. However, survey data and even real sector data itself may be less important to central banks. While no one wants a recession, officials are willing to take greater risks to demonstrate their commitment to lowering prices. The distilled message of the major central banks, but the BOJ, is that action now may preempt the need for stronger action later. 

Their mandates for price stability are not limited to demand shocks. It has become practically a meme in the financial and social media that there is little monetary policy can do to address supply-side disruptions. But there is. Under such conditions, monetary policy brings demand into line with supply. While this effort is not over, the major central banks seem to be on the cusp of slowing the pace of tightening as policy enters what are regarded as restrictive levels.  

Prices are more critical now for policy and the capital markets. Softer energy prices eased headline US and UK August inflation. It likely will be reflected in Canadian figures as well. That also means that the core rates will remain sticky. The average of the three core measures (common, median, and trim) was 5.3% in July, unchanged from June, which was a full percentage point higher than March, which was nearly a percentage point higher than the average at the end of last year (3.4%).  

Stabilization is not enough for central bankers concerned about inflation expectations becoming entrenched. After surprising the market with a 100 bp hike in July, the Bank of Canada hiked by 75 bp earlier this month and is expected to ratchet down to 50 bp at its late October meeting (26th). That would leave one session in the year (December 7), and the Bank of Canada could pause after delivering a quarter-point hike that would bring the target rate to 4.0%. 

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