Central bank pivots delayed, but still coming

We have adjusted our Fed scenario to take into account our belief that the Fed is paying more attention to actual inflation data than projections for future inflation and that it is attentive to the surprising resiliency of the US job market, with the chance that momentum remains firm until year’s end.

Monthly consumer inflation in August was higher than expected in the US, underlining the need for the Fed to stay on high alert. We now believe the Fed will hike by 75bps on 21 September, then 50bps on 2 November. We expect a final hike of 25bps on 14 December, bringing the terminal rate for the top fed funds target rate to 4.0% (versus 3.25% in our previous forecast).

As growth and employment start to deteriorate by the turn of the year, we think the Fed will cease hiking in 2023, but we are not convinced it will actually lower rates again.

A slowdown in the pace of Fed rate hikes, and ultimately a pause, could depend on the following factors: a slowdown in the non-farm payrolls figure to a moving average of 150,000 per month or lower (the current three-month average is 378,000); business indicators like the ISM purchasing manager indexes that show outright contraction in economic activity or an impending recession; a core PCE inflation figure (the Fed’s preferred inflation gauge) that falls below 0.2% month-on-month over several months (it has averaged 0.35% in the past three).

In Europe, we now expect the European Central Bank (ECB) to frontload more tightening in the coming months. Having already raised the deposit rate by 75bp last week, we expect it to do so again in October and to raise rates by 50bp in December, bringing the terminal rate up to 2.0% at year-end (versus our previous forecast of 1.50%). We forecast the SNB to deliver larger rate hikes as well; 75bp in September and 50bp in December, followed by a final 25bp rise to reach a terminal rate of 1.25% in March 2023.

In the near term, whether the ECB hikes rates by 50bp or 75bp at its 27 October meeting is a close call. But the likelihood that headline and core inflation in the euro area edges higher in September may tip the balance.

If the ECB pauses rate hikes in 2023 as we expect, it could still tighten its stance (or at least not ease it) via other policy instruments. In particular, a discussion about reducing its balance sheet will soon start. We expect Quantitative Tightening to start in 2023 via the ending of reinvestments of debt securities under the Asset Purchase Programme. The ECB’s balance sheet will also shrink as targeted long-term refinancing operations (TLTROs) mature.