While the US Federal Reserve wrapped up the year hinting at a pivot towards the end of monetary tightening, the People’s Bank of China injected more than RMB 600 billion (about USD 84.6 billion) of liquidity into the financial system. In contrast, the European Central Bank and the Bank of England sounded hawkish, while Norway’s central bank raised its key rate. All in all, market expectations of widespread moves towards monetary easing may be premature.
Arguably, positioning investments is difficult in the face of such an unclear yet apparently precarious macroeconomic and policy outlook. Nevertheless, the impact of the cumulative monetary tightening since March 2022 marks a downside risk for global growth in 2024, making a case for a defensive strategy favouring government bonds over equities while awaiting more clarity.
Hints of a policy shift
Underscoring market expectations of an impending Fed pivot is the steady decline in US inflation towards its 2.0% target from the 8.9% peak in July. Furthermore, the trend of slowing inflation appears to have gone global. Asia is making the best progress (see Exhibit 1) as the effect of energy and supply-chain shocks subside.
With (past) policy tightening expected to slow economic growth, the big question is now when, rather than whether, rate cuts will happen. So far, there seems to be no market consensus on the timing.
Last week’s Federal Open Market Committee (FOMC) meeting kept US interest rates on hold, with none of the Fed officials forecasting any need to raise interest rates further. Fed Chair Jay Powell noted in his post-meeting message that the Fed might start cutting rates before inflation hits 2.0% if the economic and inflation environments warrant it.
Crucially, the Fed’s ‘dot plot’ – which shows individual FOMC member forecasts of future interest rates – signalled a 75bp cut in the fed funds rate in 2024, with inflation projections revised down for the coming two years. Core personal consumption expenditures (CPE) inflation is now forecast at 2.4% by end-2024 and 2.2% by end-2025.
It’s all in the timing
That got the market excited, with fed funds rate futures now pricing in a 75% probability of a first rate cut in March 2024 and a 100% likelihood of it coming by May.
In our view, March seems too soon because the Fed is unlikely to cut rates while the economy is still resilient. Fiscal spending may also remain firm in the run-up to next year’s presidential election, which would keep alive the risk of a U-turn in inflation.
In our view, should the Fed see a combination of below-trend GDP growth, a looser labour market and above-target but falling inflation, it may decide to start reducing interest rates, perhaps at the May or June FOMC meeting.
The extent of such rate cuts would depend on the growth and inflation dynamics. A modest growth undershoot with a modest inflation overshoot could prompt the Fed to cut rates to 3.0% in 2024, according to our fixed income team. However, weaker-than-expected growth and inflation could prompt faster and deeper rate cuts to below 3.0%.
One common indicator that might prompt central banks to start cutting rates could be a further decline in labour costs. The recent slowing in labour cost growth (see Exhibit 2), alongside the decline in the inflation rate, mean that costs and prices are rising more slowly, but they are not yet consistent with a stable 2.0% inflation rate. Notably, Europe’s labour cost growth is stronger than that in the US.
No wonder the European Central Bank (ECB) and the Bank of England (BoE) have remained hawkish, holding interest rates stable at their meetings last week. Both BoE Governor Bailey and ECB President Lagarde argued that policy loosening was still too early, citing tight labour markets and strong wage growth. Three BoE policymakers favoured further interest rate increases, while the ECB announced that it would speed up its exit from the Pandemic Emergency Purchase Programme stimulus.
Even at the Fed, there is no unanimity about its policy easing path. In the post-FOMC interviews, Powell said the central bank is not taking the rate-hike option off the table, while FOMC members including John Williams and Raphael Bostic pushed back on rate-cut expectations.
More easing from China
China, meanwhile, was more assertive, signalling further easing measures at its annual Central Economic Work Conference (CEWC) last week.
The CEWC stressed ‘high-quality growth’ as the top priority and called for preserving stability by ‘building (new industries) first before breaking (old sectors)’. It vowed to roll out more policies to stabilise consumer and business expectations, growth and employment.
Realising that China’s property market woes are raising the risk of deflation (see Exhibit 3), the CEWC reiterated advocacy of policies to stabilise the sector, notably by accelerating urban village renovation and social housing construction, and increasing financing for viable non-state-owned developers.
Indeed, the People’s Bank of China recently announced a plan to inject more than RMB 1 trillion (about USD 141 billion) into the financial system for property and infrastructure investment in major cities. It has also drawn up a ‘whitelist’ of 50 developers eligible for credit support. The risk, however, is the implementation of these measures: many of them are still to be carried out.