Thoughts

May 12, 2023 | 15:06

Tightening Club: The Next Chapter

Economist

Jennifer Lee

Senior Economist and Managing Director
Economics

(Read more)

Jennifer Lee

Senior Economist and Managing Director
Economics

(Read more)

Central bank actions are truly all over the map these days. Sure, they are all still gunning for 2% inflation, but the major policymakers are employing different methods to get there. Look at what has happened over the past few weeks.

The BoC paused for the second meeting in a row, the RBA paused but only for a moment, the Federal Reserve hinted at a pause, and the Norges Bank continues to tighten and will give it another go in June. The BoJ is, seemingly, permanently on hold, but it is conducting a 1.5 year-long policy review. Then there is the ECB, aka the uber-hawkish central bank, and increasingly so with each passing day. Several policymakers have now introduced September into the conversation, by saying that they may not be finished tightening in July (Latvia’s Martins Kazaks), or that nothing was off the table for September (Germany’s Joachim Nagel). Meantime, the ECB’s monthly survey of consumer inflation expectations showed that the view over the next year and over the next three years increased sharply in Q2. We have now pencilled in an additional 25 bp rate hike, and look for the refi rate to peak at 4.25% by July.

The BoE meantime, raised rates 25 bps to 4.50% this week and is also not finished. Certainly not with double-digit inflation, among the highest in Western Europe. In fact, while most regions of the world (ex. Japan) are seeing inflation coming down (especially China), Britain’s inflation rate has been very sticky. The latest data for March showed that food prices soared 19.2% y/y (remember that the U.K. imports about half of its food) and it was this component that the Bank was worried about… that it would fall more slowly than it had anticipated in February. Note that some of the big supermarkets recently cut prices for bread and butter. In any event, despite concerns about inflation, the BoE no longer expects a recession. However, with such elevated levels of inflation, the central bank will need to raise rates further. We look for two more rate hikes, 25 bps each, which will ultimately take its Bank Rate to 15-year highs of 5.0%, leaving it just below Fed funds but above the BoC’s policy rate. The chance of a recession cannot be completely dismissed.

Stephen Gallo, FX Strategist, expects the Fed and BoC pauses to put near-term ceilings on the USD and CAD vs. the major European currencies over the next couple of months while central banks in the region pursue tighter monetary policies. Further out in 2023 (i.e., 6M), he expects a portion of the strength in European currencies to evaporate as the lagged impact of tightening feeds through to growth. There are also economic hard landing risks in Europe if central banks have a more difficult time bringing inflation back to acceptable rates. However, one of the biggest areas of uncertainty for the FX market is timing. There are near-term upside risks to the USD and CAD vs. European currencies if expectations for weaker economic growth in the region are brought forward, or if the USD deals with a persistent bid due to risk-off conditions in financial markets.