Surly frustrated central bankers telling euphoric markets that the inflation fight is far from over.
By Wolf Richter for WOLF STREET.
The Federal Reserve, the European Central Bank, and the Bank of England have rate-hike meetings over the coming days. And markets have set out to fight all of them. Of the two big ones, the Fed will speak on Wednesday, February 1; the ECB on Thursday, February 2. And this may turn out to be a hoot.
The ECB, which is far behind the Fed in its rate hikes and has an even bigger inflation problem on its hands, has laid out a course of rate hikes that is far steeper than markets have priced in, to the point where ECB president Christine Lagarde warned markets 10 days ago to “revise their positions,” and markets have blissfully brushed it off.
In terms of the Fed, ever since the initial lift-off rate hike less than a year ago, there have been Fed-pivot bets for a few meetings out. And they all got smacked down. But this time, the rate-cut bets are huge, practically begging for an epic smack down.
The Fed will not release at this meeting any updated projections, including the infamous “dot plot” that indicates where Fed governors see the future path of its policy rates. It releases those projections only at the four meetings that fall near the end of the quarter. The last one was released at the December meeting. The next one will be released at the March meeting.
At every single meeting since the fall of 2021, the Fed was more hawkish than at the prior meeting by projecting higher rates for longer. It has tightened the screws at every meeting. At the December meeting, the Fed projected for the first time that it would hike its policy rates above 5% and that there would be no rate cuts in 2023. Since then, every single Fed governor to speak on the topic emphasized: No rate cuts in 2023. No way Jose, the markets are saying.
It is widely expected that the Fed will hike by 25 basis points on Wednesday, bringing the upper end of the target range to 4.75%, far higher than projected a year ago. The dot plot released after the December meeting showed that a majority of the participants projected 75 basis points of hikes in 2023. This would be a 25-basis-point hike on Wednesday, one in March, and one in May. And then a pause for the rest of the year to see where inflation is going.
There seems to be no consensus at the Fed about the upcoming rate hike. Some governors came out in support of a 25-basis-point hike, others said that for them a 50-basis point hike is also on the table. The meeting could end with some dissenting votes, whichever way it goes.
The projections of 75 basis points in hikes this year and then a pause into 2024 will depend on inflation data showing “compelling” evidence, as the Fed keeps saying, that the core PCE price index, which is the reference index for the Fed, is heading back to 2%.
But on a month-to-month basis, the core PCE price index re-accelerated in December, though year-over-year it slowed to 4.4%. The PCE price index for services re-accelerated as well month to month, and year-over-year hit a new four-decade high. So, this was a step in the wrong direction.
Inflation has come down from the peak due to the plunge in fuel and a drop in durable goods prices. But it’s still very high, gasoline prices are already surging again, durable goods prices won’t drop forever, and inflation in services is red hot.
Inflation has a habit of dishing up nasty surprises. The Fed knows it, has repeatedly pointed at the upside risks to inflation, and has repeatedly emphasized the need to see “compelling” evidence that inflation has been squashed before rate cuts begin.
One of the nasty surprises that inflation dished out a couple of days ago was in Australia, where the annual inflation rate accelerated to 7.8% in the fourth quarter, up from 7.3% in the third quarter, which caused some revulsions in the money markets, as they priced in another rate hike.
In the US, the markets have brushed off any warnings about inflation and any reminders by the Fed that there would be no rate cut in 2023. And on Wednesday, the Fed will make clear once again that the inflation fight is far from over. This may turn into another classic smackdown of the rate-cut rhetoric and rate-cut bets.
During the era of money printing and interest rate repression, the sacred mantra on Wall Street was, “Don’t fight the Fed.” Now they’re all fighting the Fed with gusto, which makes for a fragile situation because the Fed is going to win, that’ll be easy.
The hard part for the Fed is winning the fight against inflation, and it may be messy, and it may take longer than expected. Last time we had this kind of inflation, it was brought under control only after many years of head fakes and nasty surprises.
The European Central Bank faces a similar situation: markets are blowing it off. Everyone expects it to hike 50 basis points at the meeting on Thursday, to bring its deposit rate to 2.5%. It has a long way to go to get into restrictive territory, with inflation in the Eurozone over 9%.
ECB officials have suggested three 50-basis-point rate hikes in a row, which would push the deposit rate to 3.5%, followed by smaller rate hikes, based on a best-case scenario of declining inflation.
But markets expect rates to peak at 3.25% by the summer, at which point the ECB would pause, according to Refinitiv data.
This is so far off the path the ECB sees that Lagarde rebuked the markets on January 19. Investors are underestimating the ECB’s commitment, she said. Investors should “revise their position. They would be well-advised to do so,” she said.
The ECB is determined to bring inflation “back to 2% [from 9.2% now] in a timely manner, and we are taking all the measures that we have to take in order to do that,” she said. Markets just brushed it off.
On Thursday at the post-meeting press conference, Lagarde will have an opportunity to throw in some frosty comments to do another market smackdown.
So we’ll have a week coming up where surly frustrated central bankers will tell euphoric markets that inflation is a serious issue, that the inflation fight is far from over, and that they’re not backing off in this fight until inflation is squashed. And this could turn out to be a hoot.
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