investment insights
Banking stress gives Fed pause. ECB’s job is not yet done
Key takeaways
- After a further 25bps rate hike in May, the Fed hinted that June could see a pause. Our core scenario foresees 5.25% as the peak of this hiking cycle and no rate cuts until 2024
- While acute stress in the US banking system appears to have subsided, if the situation worsens materially, then swift and substantial rate cuts may be needed
- The ECB also faces slowing demand and persistent inflation, but Europe’s economic cycle is some months behind the US. We see some further monetary tightening ahead, with eurozone rates peaking at 3.50% in mid-June.
The Federal Reserve (Fed) raised rates by 25 basis points (bps) as expected at its May rate-setting meeting and hinted that this may be the last hike of the cycle. We now believe that the current 5.25% rate represents the peak, although we still find market expectations of 2023 rate cuts unlikely. As the debate over future policy and rate cuts continues, much will depend on the evolution of stresses in the banking system, as well as on the trajectory of inflation and growth.
The Fed’s policy statement and press conference were carefully worded to avoid signalling a definite pause in rates come June. While the phrase “some additional firming may be appropriate” was dropped from its statement, Chair Jerome Powell stressed that future moves will be driven by the most recent data and decided on a meeting-by-meeting basis.
Crucially, Mr Powell acknowledged that banking stress and tighter credit conditions are helping delivering policy that may already be sufficiently restrictive. He stressed that a cumulative 500bps of rate tightening, ongoing Fed balance sheet shrinkage and lower credit availability are material moves, and that the full effect of monetary policy tightening will only be felt with a lag. We believe the burden of proof has now shifted for the Fed – from requiring more evidence that inflation has abated to pause, to requiring more evidence that the adjustment process is stalling to hike.
Inflation now looks to be decisively declining, falling to 5.0% in March from a high of 9.1% in June 2022. While Mr Powell noted that conditions in the labour market are still very tight, there are signs that it is no longer overheating as the adjustment towards a better balance continues.
Yet the Fed is far from declaring victory on inflation. Wage growth still looks fairly strong and services inflation is proving persistent. A favoured Fed measure of core inflation – the personal consumption expenditure (PCE) index minus food and energy costs – is still rising 4.6% year-on-year. On the whole, the underlying pace of inflation remains inconsistent with the Fed’s 2% inflation target, arguing for persistence of its restrictive policy stance.
Meanwhile, growth has slowed to a below-potential pace. US GDP grew by just 1.1% in the first quarter, and we expect it to decelerate further and even fall below zero at the turn of the year. Along with tightening credit in the banking system, a variable that the Fed is increasingly monitoring, such developments are now shifting the emphasis in the Fed’s calculus.
The big questions remain how much damage banking stress will do to the economy, and at what point the Fed will cut rates. Market pricing at the time of writing reflects a roughly 40% probability of a rate cut in July, with a full rate cut priced in by September. Mr Powell again pushed back on this idea, noting that the Fed’s rate-setting committee believes it will take time for inflation to fall, and that cuts would not be appropriate in that case. We also believe the resilience of demand and persistence of inflation makes cuts an unlikely scenario.
Meanwhile, the Fed’s assessment is that the banking system is resilient, while its emergency measures to restore liquidity appear to be working, with banks’ use of facilities steadily declining in recent weeks. Moreover, if banking turmoil worsens materially, rate cuts would likely be swift and substantial. For now, our base case remains that cuts will only take place in 2024.
ECB less advanced in its cycle
Across the Atlantic, European Central Bank (ECB) policymakers face a parallel dilemma of slowing growth and credit conditions combined with still-high inflation, but with a lag of several months from their US peers. In line with the Fed, the ECB also raised rates by 25bps in May, a slower pace than April’s 50 bps increase. But President Christine Lagarde made clear that the ECB does not intend to pause quite yet, and the ECB’s statement signalled that some more tightening is likely ahead. In addition, balance sheet tightening is about to accelerate in pace, as the ECB also announced that reinvestments under its Asset Purchase Programme will end in July.
Europe’s banks are also tightening their lending standards, although less than in the US. In general, they are more shielded from recent banking turmoil, and are larger and more strongly capitalised than their US peers, following stringent regulation imposed post-financial crisis. But financial conditions continue to tighten in line with recent ECB policy moves (including rate increases, commercial banks’ loan repayments, and a reduction in bond holdings) as well as falling appetite for loans by corporates. While Q1 GDP data confirmed the continent avoided a winter recession that many had feared, the eurozone economy only managed 0.1% growth for the quarter.
Policy tightening and lower bank lending are leading inflation down, although its downward trend is some months behind the US. While headline inflation rose marginally in April on the previous month and services inflation remained high, core inflation finally fell, reflecting an easing in underlying price pressures. Falling energy and food prices show the shocks of 2022 are being absorbed.
Still elevated inflation, the ECB’s concerns about second-round effects, and clear messaging at its press conference that it is not pausing make an additional 25bps rate hike in June likely, in our view. However, we think a pause at its 27 July meeting at a peak rate of 3.50% is more likely than not, given the continued demand slowdown and downtrend in inflation we expect between now and then. Absent any unforeseen banking stress, we also expect rates on hold for the rest of 2023, bringing growth down to just 0.7% for the full year.
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