- Time lags mean that central banks may opt to stop raising rates while inflation is still high
- But forecasts suggest that the era of cheap money is over – for now
This was the year in which central banks worldwide grappled to get inflation under control. The battle hasn’t been won yet: inflation rates are hovering around double digits in Europe and the UK; it is a sign of the times that there was cautious cause for celebration last month when US inflation fell to ‘just’ 7.7 per cent.
For now, policymakers are continuing their offensive. In late November, the Bank of England’s (BoE) Dave Ramsden warned that he would advocate a “forceful” policy response if data suggested persistent inflationary pressures. The European Central Bank’s Isabel Schnabel was even more forthright: she argued that the biggest risk for central banks was underestimating the stickiness of inflation – and getting policy wrong as a result.
This is a global problem: last month, the OECD argued that fighting inflation must be the “top policy priority right now”, and advocated for continued monetary policy tightening in countries where inflation remains high and persistent.
As the first chart shows, the opening rounds of the fight against inflation have been characterised by swift (once they got started, at least) and steep interest rate hikes. The Bank of England has moved at speed: Bank Rate stood at just 0.25 per cent last December and had risen to 3 per cent by the time of going to press. If consensus estimates are correct, the base rate will be 3.5 per cent by the time you read this.
As the year draws to a close, interest rates seem to be marching determinedly upwards. But the end of rate hikes could come sooner than we think.
Decoupling from inflation
The case for a pivot is not as outlandish as it sounds. Monetary policy carries significant time lags, and ING Research’s global head of macro, Carsten Brzeski, agrees that central bankers have increased rates in a hurry. ING analysis suggests that it takes between six and nine months for monetary policy changes to filter into the real economy – meaning that central bankers are only just beginning to see the impact of their earlier hikes.
The full effects might not be felt for even longer: academic research has found that monetary policy transmission can often take closer to two-and-a-half years. With the global economic outlook darkening and the impact of rate hikes yet to filter through, central bankers are beginning to run the risk of monetary policy ‘overshooting’ and depressing already-weak economies.
This means that rate hikes might come to a halt surprisingly soon – and while inflation is still surprisingly high. Analysts at Goldman Sachs looked back at 85 hiking and easing cycles from 1960 onwards and found that central banks tended to stop raising rates when inflation was within 10 per cent of its peak. This looks unfeasible today: given our eye-watering inflation rate, it would mean the BoE easing off while inflation was still in double digits. But if history is a guide, it means that rate hikes could stop when inflation is far closer to its peak than to the 2 per cent target.
For all the words of Ramsden et al, the BoE was also clear last month that it did not believe the base rate would rise as much as markets expect – traders were at the time predicting a peak in excess of 5 per cent. If the true peak is closer to 4 per cent, basic maths says the hiking cycle is almost complete.
Moving to a ‘probing’ strategy
If the economy continues to stumble, attention could turn to rate cuts. In reality, policy pivots will probably be more of a meandering change of course than a sharp about-turn. Central banks will first begin to slow the pace of rate increases through a series of smaller hikes, as may now be the case in the US. Next, rates will reach their peak (or terminal) level, and sometime later policy will truly change direction as interest rates are cut.
Goldman Sachs analysis of past hiking cycles found that they typically lasted 15 months. Taking this as a rule of thumb would put the UK on course for a final rate hike in the BoE’s March rate-setting meeting next year. Interestingly, this isn’t far off analysts’ predictions: Brzeski is not alone in thinking major central banks will slow their tightening efforts from this December, before eventually ending them in the first quarter of next year.
AXA group chief economist Gilles Moec thinks that we will have reached “the end of the beginning” of monetary tightening, when central banks keep hiking, but do so at a less brisk pace. Yet Moec reminds us that there is not a direct link between slowing down the pace of rate hikes and hitting the ‘goldilocks’ terminal interest rate that will return inflation to 2 per cent.
He argues that the last phase of the tightening cycle will see central banks move away from “catching up” and towards a “probing strategy” where more tentative rate changes are tested. In a similar vein, Fed officials once colourfully compared the challenges of setting monetary policy to walking in a dark room with no shoes on and treading carefully to avoid stubbing your toe.
This all means that the path to the elusive terminal rate might not be smooth. Goldman Sachs historical analysis found that the majority of hiking cycles featured a pause, where rates plateaued, only to increase again. It may prove difficult to tell the wood from the trees next year: ING’s Brzeski expects that the end of the tightening cycle will initially be conveyed as a “taking stock pause”, rather than an explicit end to hikes.
The end of cheap money
Although the end of the hiking cycle may be coming into view, the start of the easing cycle is harder to spot. As the second chart shows, there may well be a substantial lag between the final rate hike and the first rate cut. Data from Consensus Economics suggests that even if UK interest rates reach a peak in March 2023, it could be a year before they start decreasing again.
Historical research from Goldman Sachs points to a steeper pivot: on average, rate cuts came seven months after the last hike, and amounted to a hefty 2 percentage point easing within the first 12 months. But even cuts of this magnitude would not return interest rates to the very low levels that we saw this time last year.
As far as 2023 is concerned, higher rates are here to stay. But this raises an important question: if the global financial system has become accustomed to cheap money, how will it cope with a sustained period of higher interest rates?
Harvard professor and former Federal Reserve board governor Jeremy Stein is among those arguing that aggressive policy tightening has raised concerns about “what could break”, and warns that central banks may find themselves in a tight spot if measures to improve financial stability risks run counter to the goal of slaying inflation. The UK experience in September, when the BoE was forced to intervene in gilt markets in the middle of its hiking cycle, may be an apt example here. Goldman Sachs analysts rattle off a list of other risks to watch out for: illiquidity in sovereign bond markets, open-end bond funds and pressure on EM borrowers owing to dollar strength. It ends with the ominous reminder that there are also risks from the “unknown unknowns” that nobody is looking out for at all.
How will interest rates impact investments in 2023?
This all makes for a challenging investment climate. Thomas Matthews, senior markets economist at Capital Economics, notes that this year’s rising real yields have been bad news for riskier assets. Matthews expects yields to fall next year as bond prices rise in response to central bankers softening their stance. But he cautions that lower yields won’t necessarily equate to better news for risk assets if fears about the outlook for global growth drag on equities and corporate bonds.
Yet as 2023 progresses, the outlook may start to improve. Matthews expects next year’s global economic downturn to be brief, and sees risk assets rallying if the outlook brightens by the middle of next year. Mark Haefele, chief investment officer at UBS Global Wealth Management, also anticipates that falling inflation and the end of the hiking cycle should present a “more supportive backdrop” for markets.
For now, Haefele notes that defensive sectors such as consumer staples and healthcare should provide some insulation from lower growth expectations. Although he advocates a defensive posture as we enter the new year, he argues that “it is also important for investors to stay invested in line with longer-term plans, and retain upside exposure so that portfolios do not get left behind as markets attempt to anticipate a turning point”.
But this does come with a health warning: both inflation and interest rates could (and probably will) surprise us again next year. UBS analysis identifies an upside scenario where inflation falls rapidly as supply chains ease, allowing central banks to cut rates faster than expected. But there is also the downside risk that persistent inflation delays rate cuts or even precipitates a new round of hikes. Tellingly, Goldman Sachs analysts caveat their historical research with the observation that “the current post-pandemic cycle remains very unique”. After all, if 2022 has taught us anything, it is that we are living in unpredictable times.
