In just two weeks, market expectations for monetary policy easing have changed significantly. Two 25bp interest rate cuts by the US Federal Reserve (Fed) and the ECB have largely been taken off the table. Government bonds have suffered as a result, but risk assets are still in good shape thanks to strong corporate fundamentals.
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There was a degree of euphoria after the mid-December meeting of the Federal Open Market Committee (FOMC) as investors sensed an impending ‘pivot’ in the Fed’s policy towards easing. The party was good while it lasted, but by February market views had changed dramatically (see Exhibit 1). The start of rate cuts has been postponed.
Market expectations for the number of cuts in 2024 are now more in line with economists’ forecasts and with those from the Fed itself.
Cuts in key interest rates are still expected, but later and not as large as previously hoped. Since the FOMC meeting on 30-31 January, comments from officials have been consistent: There will be no rate cuts until they have ‘greater confidence that inflation is moving sustainably toward [the Fed’s goal of] 2%’.
Could inflation rise again?
Consumer and producer price indices published over the last week were an importer factor behind the change in market sentiment. The acceleration in month-on-month US core inflation from 3.3% in December (trailing three month average) to 4.0% in January was not at all what the market expected. Inflation nonetheless looks likely to continue declining this year, albeit more slowly than it did in 2023.
An update on the Fed’s preferred inflation measure – the personal consumption expenditures (PCE) index excluding food and energy – is due on 29 February. It is also likely to show a rise in January. According to the Bloomberg consensus as at 21 February, the PCE index is expected to rise by 5% (annualised) in January compared to December, double the rate in the prior month.
Consumers’ perception of inflation
The New York Fed consumer expectations survey for February found that people’s views on inflation over the next one and three years have returned to normal levels (see Exhibit 3). However, it remains to be seen whether the latest inflation data changes those perceptions.
The perception of inflation is pivotal to central bank thinking.
The Bank of Canada (BoC) recently raised concerns about household inflation expectations, pointing out that “the decline in short-term inflation expectations had slowed, and these expectations remained elevated”. BoC officials noted that “this probably reflected consumers’ recent experience with inflation — especially continued large increases in grocery prices and rising shelter costs. [They] believed that consumers needed to see inflation come down further for expectations to decline”.
The ECB pointed out in its first Economic Bulletin of 2024 that the December Consumer Expectations Survey (CES) was quite detailed in reporting the perception of past slower inflation, noting:
“With regard to perceptions of past inflation, they did not follow the decline in Harmonised Index of Consumer Prices (HICP) inflation between June and October 2023. However, they eased considerably from October 2023 onwards, with the median declining from 8.0% in September to 6.2% in December.”
The results of the January CES are due on 23 February. It will be important to see if this trend continues.
Inflation or growth? Both matter
The Fed’s policy rate deliberations depend on two main variables, inflation and economic activity.
Recently, central bank comments have focused on inflation, welcoming its slowdown while not yet declaring victory.
This is probably why monetary policy expectations barely changed when US activity indicators disappointed, as US retail sales did last week. They fell by 0.8% in January (far more than expected) and the figures for November and December were revised down, too.
Weak retail consumption is likely to lead to a revision of fourth-quarter private consumption (a key component of GDP). The advance estimate of GDP showed consumption rising at a 2.8% annualised rate. The next revision is due on 28 February.
That said, the Atlanta Fed’s running estimate of first-quarter GDP growth is 2.9% annualised according to the latest update on 16 February, still quite a robust pace.
The picture in the eurozone is rather different. Growth stagnated in the fourth quarter and this has started to weigh on employment. On the other hand, business climate indices were better in January and February, largely due to expectations of ECB rate cuts.
The ECB’s negotiated wages indicator fell from 4.7% year-on-year in the third quarter to 4.5% in the fourth, offering arguments to both hawks and doves: wage increases are still high, but no longer accelerating.
Rest assured: Policy rates will fall
Some market observers have noted that economic conditions in the eurozone justify a rapid and aggressive ECB easing cycle. Several ECB governors recently pointed out the risk from deciding to cut rates too late and then having to over-adjust as more aggressive cuts could increase financial market volatility.
However, at her hearing at the European Parliament on 15 February, ECB President Christine Lagarde warned that ‘the last thing [she] would want to see is us making a hasty decision, [only] to see inflation rise again and have to take more measures”. The risk of second-round effects was also mentioned by ECB council member Isabel Schnabel.
Despite the US and European economic cycles being out of sync, adjustments in ECB monetary policy expectations have come mainly on the back of US indicators and comments.
With such dithering still going on (except in Japan, where monetary policy remains ultra-accommodative), the transition from the 2022-2023 tightening cycle to easing in 2024 is still ongoing. The Fed, for its part, believes it can wait before starting to cut given still resilient growth.
The resulting uncertainty on financial markets could persist in the short term and delay the onset of a renewed upward trend in bond and equity prices after the ‘everything rally’ at the end of 2023.
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