Central Banks Are All Over the Place Creating Uncertainty

Uncertain Monetary Environment

Most major central banks around the world have been hiking rates aggressively from as early as late-2021, in an effort to bring down surging inflation, as a result of the massive monetary and fiscal stimulus implemented to combat the economic fallout of the Covid-19 pandemic, trade disruptions and other factors.

Although not completely in tandem, most central banks have generally been on the same page up until recently, delivering historically large rate increases. As of the time of writing (12 May 2023), this is the cumulative tightening and start dates:

-Fed: 500 basis points, started in March 2022
-ECB: 375 basis points, started in July 2022
-BoE: 440 basis points, started in December 2021
-RBNZ: 500 basis points, started in October 2021
-RBA: 375 basis points, started in May 2022
-BoC: 425 basis points, started in March 2022

During the current year however, we have seen progressively different approaches, as CBs move closer to the end (or already there) of their tightening cycles. They have been increasingly data-dependent as they try to balance between often competing data and have been adopting divergent approaches, while the recent banking turmoil added another level of complexity. The Bank of Japan meanwhile has been an outlier, since it is still on loose monetary policy setting, but prospects of normalization mount.

Policymakers definitely have a very difficult job and communication has often been unclear, as they consider a shift in their stance. This creates an uncertain monetary policy environment that can continue to be a source of volatility, as markets try to guess the next steps.

US Fed

The US Federal Reserve begun its rate hiking cycle timidly in March 2022, but quickly picked up speed, becoming more aggressive. The current year started with a slowdown in the pace of tightening and Chair Powell speaking a lot about the "disinflationary process" being underway ^[1], as price pressures were subsiding. However, as later data pointed to persistent inflation and a strong labor market, he became more hawkish and by early March he had opened the door to a reacceleration in the pace of tightening.

It was around the same time that the Silicon Valley Bank collapsed ^[2], sparking fears around the financial system. The fallout led to more bank failures, such the one of First Republic ^[3], forcing the Fed into a more conservative approach, due to the expected credit tightening from these developments.

Back in March, Mr Powell had equated this tightening with a rate hike or even more ^[4] and on this month's press conference he said that credit conditions will be of "particular focus" going forward ^[5]. At that meeting, the Fed raised rates again but made a dovish shift to its statement that opened the door to a pause, which would be in line with its own projections and market pricing.

Markets are actually more dovish, anticipating rate cuts later in the year, but chair Powell dismissed such expectations. However, inflation is still far from the 2% target and the labor market is very tight with elevated wages and Unemployment at five-decade lows, which calls for restrictive stance and makes the job of Fed officials very tricky. Even the Fed holds rates next month, it is unlikely to speak of a "terminal" rate and more likely to maintain optionality.

European Central Bank

The European Central Bank started raising rates later and from a lower point, compared to its counterparts and despite doing so very aggressively, it still has more ground to cover. In the wake of the SVB collapse that spilled over into Europe as well, the ECB adopted an opposite approach from its US counterpart.

It stayed on course in March and President Lagarde drew a clear distinction between financial stability and price stability, speaking of "no trade-off" ^[6]. After this month's policy meetings, the two central banks continued to drift apart, since European policymakers slowed the pace of hiking, but pointed to more moves. Ms Lagarde did not leave any doubt around that, saying that "we have more ground to cover" and that "we are not pausing, that's very clear". ^[7]

Bank of England

The BoE was the first of the Big-3 to raise rates, all the way back in December 2021. It started off with small increments and gradually became more aggressive due to the high cost of living. Over recent months it seemed to be hiking reluctantly, due to the economic slowdown and has been offering no guidance, in anyways typically vague language.

This week it hiked rates by 0.25% and remained non-committal around future moves. Inflation is still very high though and despite expecting it to fall sharply, it raised its forecast. More to it, the UK economy has fared less bad than feared and the central bank upgraded its GDP projections, not seeing a recession anymore. These forecasts are based on rates peaking at 4.75%, from 4.5% currently. ^[8]

The above factors suggest there is still room for more hiking, but murky guidance creates uncertainty. Speaking on Bloomberg after the decision, governor Baily touted data-dependence, noting that they are "approaching" a point when they should be able to "rest". ^[9]

Reserve Bank of New Zealand

The RBNZ beat everyone to punch, since it embarked upon its prolonged rate hiking cycle in October 2021, two month before its UK counterpart. It has been consistently hawkish, leaving little doubt about its priorities.

Ahead of the most recent meeting in April, baseline expectations were for a smaller rate increase than in the past, but the Reserve Bank of New Zealand did not yield and delivered another outsized 0.5% hike ^[10]. The Board viewed inflation as "still too high" and even though it moderated further since then, with a 6.7% print in Q1, it remains far from the target. Furthermore, wages are at the highest levels since 1992 and the unemployment rate close to historical lows.

Officials were less clear as to the next steps this time around though, only noting that the official cash rate needs to be at a level that "will reduce inflation and inflation expectations", in a sign that they may be nearing a peak. Based on the bank's last projection, officials project a terminal rate 5.5%, showing that there is room for more firming, from current 5.25%.

Reserve Bank of Australia

Back in April, the RBA had paused its tightening path after around a year of consecutive hikes, in order to assess the cumulative effect and incoming data, not ruling out further moves though ^[11]. After this decision, CPI inflation eased to 7.7 y/y in Q1 and markets were expecting that officials would stay on the sidelines again.

That did not turn out to be the case though, as the RBA restarted its hike cycle in May, with a quarter-percentage increase, as inflation is "still too high" and the labor market "very tight". More to it, they kept further increases on the table, noting that "some further tightening" in monetary policy "may be required", to make sure that inflation falls back to the 2-3% target in a "reasonable timeframe". ^[12]

Bank of Canada

The BoC was the first major central bank to hint at a pause at the start of the year, following through in March, since it held the policy rate at 4.5%, after around one year of hikes ^[13]. Policymakers maintained their holding stance again in the most recent meeting last month. ^[14]

Inflation readings have allowed them to do so, since it has been coming down and they expect it to hit 3% by the middle of this year and the 2% target by the end of 2024. However, the kept options open, warning that they remain "prepared to raise the policy rate further" if needed.

Bank of Japan

The BoJ is the outlier since it is on the opposite side of the monetary policy spectrum, employing negative rates, yield curve control and quantitative & qualitative easing. This is an ultra-dovish setting, although it opened the door to policy normalization with the widening of its yield-curve control in December 2022, in a move that shocked markets. ^[15]

This process however, is unlikely to be swift or straightforward and odds are that it will be a source of volatility. Further rise of the yield target would seem like a reasonable first step, but markets may attack it immediately, so scrapping it altogether could be a consideration.

So far, the central bank has not moved further and the new governor has not shown any intention to challenge the status quo. In the first policy decision under Mr Ueda's guidance, the BoJ did not make any changes. ^[16]