Fed Chair Powell 

Fed Chair Powell spent the second half of 2021 telling the financial markets that the rise in inflation was transitory. It is easy to say now that this was a mistake, but the market fell for it. Fast forward to today, and Powell seems to be suggesting that a high terminal fed funds rate will be anything but transitory. This too will prove incorrect.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said it would be very important to understand the messaging that Fed Chair Powell and other central bankers are employing at this important stage of the economic and monetary cycle. The Fed, the ECB, the Bank of England and many others are at a stage of the cycle where it is crucial for them to sound hawkish, and so imply that high policy rates will endure for some considerable time until inflation comes back to target.

It is an important period because central banks are working hard to tackle the infamous “second round” inflation effects. The first round of price pressure came largely from factors outside of central bank control such as supply-chain difficulties created by the pandemic and the gas price surge caused by Russia’s invasion of Ukraine. But now the danger is that this price pressure sets off second round effects such as large wage rises as workers attempt to keep up with soaring inflation.

This is where the anti-inflation credibility of the central banks kick in as they essentially tell the public that if wages and other prices are bid up aggressively they will keep rates higher for longer. So, we would absolutely expect central banks to be making these sorts of higher-for-longer noises right now. In an ideal world, just making these threats might prove sufficient to keep second-round pressures in check.

Just as financial markets seemed to fall for the ‘transitory’ story in the middle of 2021, there is a danger that the market falls for the higher-for-longer story now. If you don’t believe that the market fell for the transitory story in the middle of 2021, just consider that the futures market at that time implied only one 25-bps rate hike from the Fed through to the end of 2022. In the event, the Fed ended up lifting rates by 425-bps! Fast-forward to today and the market is priced for 75-bps of rate cuts by the end of 2024.

In contrast, Mr. Steve Barrow thinks the Fed is more likely to cut by 200-bps. Quite clearly, a part of the reason for this forecast is down to the fact that we see the development of the economy as being conducive to rate cuts of this magnitude. But, a part is also due to the Fed’s messaging. For when the Fed gets comfortable with the extent and longevity of the fall in inflation, it will be like the flick of a light switch, with the Fed’s language quickly turning much more dovish and then rapidly following this up with rate cuts.

FOMC officials cannot talk about any such easing cycle right now; firstly, because it is possible that the Fed might have to hike rates again, and secondly because any discussion of future easing undermines the tightening of policy that has been carried out to date. But, when the turn comes, or the light switch is flicked, it will be rapid and aggressive.

This story does not just apply to the Fed. Some other central banks release their own forecasts for rates and usually these represent the collective judgement of the bank, not an amalgam of individual forecasts as we see from the FOMC members. What surprises us even more than the Fed is that some of these other central banks suggest an even higher, for even longer, strategy.

For instance, the Reserve Bank of New Zealand releases rate forecasts and is predicting that rates won’t start to come down until 2025. But we would be astonished if the first rate cuts don’t start next year given that the economy is in a deeper hole than many others. So, here too anti-inflation bravado seems to be infecting the Bank’s message to the market and to the public. But this message will soften considerably and soften quickly, probably through the first half of next year, just like the Fed.