Good Morning!
Big week for central bank watchers. The U.S. Federal Reserve, European Central Bank and Bank of England will all make rate decisions, following the Bank of Canada last week.
Until recently predicting what a central bank in an advanced economy was going to do was simple, says BofA Securities global economist Ethan Harris.
“Most were six months or so behind the curve and would keep hiking until they caught up,” he wrote in a recent note.
“Now with policy rates in the neighbourhood of neutral, forecasting is becoming a lot more nuanced.”
By all accounts, this has been an extraordinary cycle. A pandemic, then a war fanned inflation to levels not seen in decades. Central banks have responded, though some say a little late, with the most aggressive hiking cycle in recent history.
Now the pace of rate hikes is slowing and some central banks, such as the Bank of Canada, are signalling they are ready to pause.
“However, the war on inflation is not over and it would not be surprising if some banks paused only to start hiking later,” said Harris.
Harris backs up this view with three points. First neutral rates — when interest rates are neither accommodative or restrictive — vary across countries and can be difficult to pin down. “To some degree central banks will only know what the neutral rate ‘was’ with the benefit of hindsight,” he said.
Second, inflation might not come down as much as central bankers hope. While it appears to have peaked with the easing of commodity prices and supply chain disruptions, wage and service price inflation could prove more sticky, he said. There is also the danger that inflation expectations stymie a return to the central banks’ targets.
“How would central banks respond?,” said Harris. “They could maintain high real rates for a longer period of time or, if the disinflation stall-zone is high enough, they could resume rate hikes.”
Lastly, investors have gotten used to the idea of smooth hiking cycles, but historically this has not always been the case. There are plenty of examples of pauses followed by additional hikes in the past and Harris believes high inflation makes this more likely today.
Norway’s Norges Bank is an example of a pause not meaning done. The first central bank to respond to rising inflation, it hiked in September 2021, six months earlier than its peers. The Norges Bank hiked in December, paused in January and is now signalling one more hike in March.
The Bank of Canada, which has often followed the Fed, changed course this past week by being the first major central bank to signal a pause.
Some economists see its rate going no further than the current 4.5 per cent, but “the risk of more hikes is not going away quickly and cuts are nowhere in sight,” said Harris.
The Fed went from being one of the most dovish central banks to one of the most hawkish. BofA thinks it will make three more 25-bps hikes and that the market is pricing in rate cuts too early.
