Higher for longer
The message that most central banks have been trying to push throughout their hiking cycles has been to expect rates to rise and remain elevated. It is the ultimate level of rates more than the speed at which they rise that determines how the economy receives monetary tightening. At least in the case of the UK, the Eurozone and the US, the job of breaking new ground with higher rates appears to be done. Only a few months ago, the Federal Reserve was still forecasting a final hike in December. With the Fed’s latest decision due tomorrow, that possibility has been all but been extinguished from market pricing and expectations.
With rates still in enormously restrictive territory, the job for central banks will be to convince the market that these levels are likely to stick around for longer. The reason that central banks would wish to do so whereas the wider market would not is to support the path of inflation back towards its target. If markets price in rate cuts prematurely that represents a real effective monetary loosening for the underlying economy. Everything from FX contracts to mortgages are based upon the market pricing of credit, not overnight rates from the central bank. Central banks will therefore be cautious that not striking a tone strict enough to scare markets into pricing a pause in rates at this lofty level could undermine progress made on inflation.
This week’s decisions by the ECB and Bank of England that will follow one day after the Fed’s publication come at a difficult time to support such narratives. There has been a significant repricing of the short end of the interest rate curves behind GBP, EUR and USD. This has already led to a material easing for financial conditions despite no change at the central bank level. It would be one thing to support stable rate expectations, but it is another entirely to reverse a trend currently well underway. So far markets expect a more aggressive but delayed start to rate cuts in the UK versus the Eurozone. Should that pricing change, a challenge to GBPEUR spot levels would ensue.
Discussion and Analysis by Charles Porter
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