- ECB, Fed and Bank of England hike rates by 50bp
- ECB will go even further
- In doing so, the ECB is taking the risk that the recession will deepen
- US inflation at peak
- China weak, says goodbye to zero-covid policy
Google Translated from Dutch to English. Here is the link to the original article in Dutch. The article was originally published on 16 December 2022.
The ECB was late in implementing interest rate hikes to combat inflation, much later than, for example, the Bank of England, the Fed and even much later than, for example, the central bank in Brazil. ECB president Lagarde long gave the motivation that our inflation was very different from elsewhere. In the meantime, the central bank in Brazil seems to have stopped raising interest rates and the end of the process of interest rate hikes in the US and the UK is in sight. But not with us. The ECB is far from finished. That in itself is understandable, because our official interest rate is lower than elsewhere and our inflation is higher. Still, I was surprised when Lagarde actually said that the reason for our continued interest rate hike, while other central banks seem to be stopping, is that our inflation is very different from elsewhere. So the motivation to do nothing at first is now the reason to take action. Same analysis, but the opposite policy response…
I struggle with it a bit. In principle, I welcome a normalisation of interest rates, but preferably at the right time and that is where the ECB is failing in my view. When the economy grew strongly, the ECB kept interest rates below zero. And now that the economy is heading into recession, the hawks are in control and interest rates are being raised at a rapid pace. It is of course still historically low and also much lower than inflation, but such a sharp increase still has a significant impact.
In the ECB's models, market interest rates are an important determinant of inflation. So maybe Lagarde tried to give interest rate expectations a strong boost yesterday. Did that work? The Dutch capital market interest rate, the effective yield on 10-year government bonds, rose by about 20 basis points during the press conference.
It should be noted that the ECB's models have not exactly shrouded themselves in glory in recent years. That in itself is not surprising, because the economy has been hit by a series of unprecedented shocks, from the pandemic to the aggressive stimulus measures by governments and central banks and from the exploded European gas price to the sharp rise in capital market interest rates this year.
The difference between the development of the capital market interest rate and the ECB interest rate this year is interesting. While the ECB was still in denial, capital market interest rates rose. The effective yield on 10-year Dutch government bonds started the year at around 0% after 2020 also recorded -0.5%. There was an increase at the beginning of this year. When the ECB raised official interest rates for the first time on 15 June, the effective yield on 10-year Dutch government bonds had already risen to over 2%. Subsequently, that effective yield reached a provisional high of around 2.75% in the latter part of October. I checked the numbers; Until the early 1960s, capital market interest rates in our country had never risen so sharply in percentage points in a period of 10 months as this year.
The ECB has now raised interest rates four times (including yesterday) by a total of 2.5%. And yesterday, Lagarde predicted a further increase of at least 1%. My conclusion is that the market has seen it all much better than the ECB. I therefore found the performance of Lagarde cringing, who more or less said that the market really sees it wrong.
Capital market interest rates have fallen again in the last two months. Instead of arguing that the market understands little of it, the ECB should ask itself what the message is that the market is now sending. The message seems clear to me: a recession is coming. In the past, recessions have proved to be a significant pressure on inflation. The market tells the ECB that no further rate hikes are necessary. Earlier this year, the market told the ECB that interest rates really had to go up a lot. The ECB listened much too late. In my view, by not listening to the market again, the ECB is taking the risk of making the recession unnecessarily deep.
The central bank of Brazil seems to have stopped raising interest rates and the Fed and the Bank of England also seem to be ending interest rate hikes. But not with us.
US inflation past peak
US inflation is now down for five months in a row, core inflation for two months in a row. In November inflation was 7.1%, after 7.7% in October. Core inflation also fell, from 6.3% to 6.0%.
Source: Refinitiv Datastream
I suspect that inflation in the US has indeed peaked and that a recession in 2023 will push that inflation further. It is important to realize that rents have a large weight in the American inflation basket (approximately 31%). Rents follow house prices in the US with some lag. The increase in rents has now risen to 7.1%. The next picture shows that house prices have started to fall. The rent increase will also reverse in the course of next year, but that may take some time. The Fed's 2% inflation target will therefore not be in sight very soon.
Source: Refinitiv Datastream
The probability of a US recession
Falling inflation makes it more likely that the US economy will avoid a recession, according to Fed boss Powell. The bond market is sending a different signal. The yield curve, the difference between interest rates on longer-term and shorter-term bonds, or money market interest rates, has been negative for some time. The next picture shows the interest rate difference between 10-year and 2-year government bonds. Every recession has been preceded by a negative interest rate differential and the current interest rate differential is greater than we have experienced in the last 40 years. That proves nothing. But to say that the US will not enter a recession is a view that is at odds with the experience of the last 50 years.
Source: Refinitiv Datastream
It is undeniably true that the US economy currently appears robust. Still, I would take the message of the yield curve to heart. Although inflation is falling, purchasing power is also eroding in the US. So far, consumers continue to spend money imperturbably. The question is whether it will stay that way. Currently, American families save little. In October, only 2.3% of disposable income was saved, the lowest saving rate in at least 17 years. They can afford this because there was a lot of saving during the pandemic, but you would still expect an increase in the savings rate in the foreseeable future, which will depress consumer spending. Retail sales in November were much weaker than expected. Perhaps this is the first sign of a slowdown in consumption growth, although we should realize that single-month figures do not yet form a trend.
Source: Refinitiv Datastream
However, it seems that the bottom has passed. Production is increasing again. And that increase is faster than domestic sales. German car exports are therefore on the rise again. The next picture shows the difference between production and license plate registrations. Of course, imported cars are still in between. Yet it is significant that a tipping point seems to have been passed.
China weak, says goodbye to zero-covid policy
We have known for some time that the Chinese economy has weakened considerably this year. The real estate sector is in dire straits and construction activity is declining sharply. The zero-covid policy has also led to regular lockdowns. This limits production and consumer spending. In November, industrial production was only 2.5% higher than a year earlier. That is a low figure for China. In October it was still 5.0%. Retail sales in November were even 5.9% lower than a year earlier, a lot worse than October's 0.5% drop. The government has now decided to say goodbye to the zero-covid policy and society seems to be opening up completely. That will benefit business, but given the moderate effectiveness of the Chinese corona vaccine, it could just lead to a large spread of the virus. If that leads to a large number of mutations of the virus, it could also affect us. It is unpredictable how policymakers will react to this.
Closing
The ECB, the Fed and the Bank of England raised all three official interest rates by 50 basis points this week. The message differed. At the Bank of England, two members of the policy committee voted against a rate hike, and Fed documentation shows that decision-makers there only foresee a limited further rate hike. The ECB started later and is not finished yet. We have to count on at least another 100 basis points increase, possibly more. In my view, the ECB is taking the risk of causing unnecessary damage to the economy.
Inflation in the US has been falling cautiously for months. That process will undoubtedly continue, but it will take some time for inflation to get close to the Fed's target of 2%. While many economic indicators show that the US economy is currently robust, the yield curve says a recession is coming. I wouldn't ignore that warning.
The Chinese economy is remarkably weak. The problems in the real estate sector, combined with the frequent lockdowns, are taking their toll. The government has decided to jettison the zero-covid policy. This is good for business but could lead to a new large-scale spread of the virus. Honestly, I'm holding my breath.
