The Fed's relentless hiking cycle went up a notch this week as the FOMC signalled a more aggressive approach was required to curb inflation in the US. This pulled 4 other G10 central banks into delivering a total of 275bps of rate hikes this week, but those efforts were insufficient to 'out hawk' the Fed, sending the US dollar ever higher. Against the tide, the Bank of Japan continued to hold policy unchanged, but the situation prompted intervention in the FX market to defend the Yen for the first time since the late 1990s. Bond markets, already under pressure from rising rates, reacted poorly to the announcement of a significant fiscal stimulus package in the UK. Gilt yields soared in response, heaping more pressure on the Sterling, with markets also contending with the confirmation from the Bank of England that it will soon commence selling down its bond holdings.
Fed presses on with rate hikes...
The Federal Reserve's FOMC ramped up its response to high inflation in the US, not only hiking rates by 75bps but also signalling a higher peak in the fed funds rate than expected by markets, some 125bps above its current level of 3 to 3.25%. Committee Chair Jerome Powell said in the post-meeting press conference the FOMC was "purposefully" raising rates to a "sufficiently restrictive" setting that will likely be needed "for some time" to lower inflation to its 2% target, with additional tightening to come from the reduction of its balance sheet that is now running at its top pace of $95bn/mth.
Chair Powell said that with the strong labour market generating upward pressure on wages and prices, longer-term inflation expectations risked becoming unanchored from the Fed's target. Accordingly, a more aggressive approach from the FOMC was signalled, with its median projection for rates rising to 4.4% by the end of the year (up from 3.4% in June) and lifting further to peak at 4.6% in 2023 (3.8%). Although rates are seen on a falling trajectory from 2024, the updated projections indicate the fed funds rate is likely to remain in the restrictive zone until at least 2025.
... but faces an increasing trade-off
That is how long the FOMC sees it will take for inflation to return to target on both a headline (2.0%) and core (2.1%) basis. This comes after the inflation projections for 2022 and 2023 were revised higher. The trade-off is significant, with more rate hikes seeing the growth outlook slashed to 0.2% this year from 1.7% in June and then to 1.2% in 2023 (from 1.7%) and 1.7% in 2024 (from 1.9%). Growth running below potential for that sustained period—something Chair Powell said was needed to lower inflation—puts the unemployment rate on an upward path, rising from 3.8% by the end of the year to 4.4% by 2024.
Bank of England hikes into a complex outlook
The BoE hiked rates by 50bps to 2.25% as the UK's complex economic backdrop resulted in the first 3-way vote from the 9-member Monetary Policy Committee in over a decade. A majority of 5 votes sealed the decision over 3 members who voted for a larger 75bps hike. The incoming member on the MPC, Swati Dhingra (replacing Michael Saunders), cast a sole vote for a 25bps increase. The MPC also gave the green light to its earlier announced plan for balance sheet reduction, voting unanimously for an £80bn reduction over the 12 months to October 2023. This will include around £40bn of gilt sales, of which £8.7bn is planned for the first 3 months.
At cross-purposes to the BoE hiking rates, the government announced around £160bn of fiscal stimulus measures to impact the economy through to 2025/26 under its Growth Plan 2022. This includes a provisional £60bn to cover the government's price cap on energy bills. In its decision, the MPC noted the energy price cap will likely lower the peak in inflation from 13% to 11% in Q4 and cut 5ppts from headline inflation in 2023. However, over a medium-term horizon, it would add to inflationary pressures as it will help support household demand. The Sterling deteriorated further and gilt yields surged on the back of this week's developments, reflecting rising inflation risks and concerns over UK public finances.
Given the associated uncertainties, the guidance from the MPC remained that rates are "not on a pre-set path", pledging also to act "forcefully" to signs of inflation becoming entrenched into the price- and wage-setting process. The path for rates will depend heavily on the Bank's revised assessment of the economic outlook, taking into account the effects of the government's fiscal stimulus, to be published at the November meeting.
RBA to weigh its options
The minutes from the RBA's September Board meeting were notable in that they revealed the Board held a discussion over whether to hike rates by 25 or 50bps. Ultimately the Board decided on 50bps, but this is a significant development given speculation of a slowing in the pace of tightening only started after the meeting when Governor Lowe removed the reference to "normalising" rates in his statement. At last week's parliamentary testimony, Governor Lowe told members that as rates rise higher "...the need for big adjustments gets smaller" and that the same discussion over hiking by 25 and 50bps would take place in October.
The overall impression is that the RBA is becoming more mindful of the risk of overdoing tightening, with the minutes noting the Board was "resolute" in the need to lower inflation to target but also needed to take into account the "risks to growth and employment". Adding to the sense of caution is the global economy where the effects of rising rates, the war in Ukraine and a slowdown in China due to Covid are presenting downside risk for Australia. As Governor Lowe noted in his address last week, a soft landing domestically would be harder to achieve if there was "further material bad news on the global economy".