As markets await the all-important interest rate decisions from the Federal Reserve, Bank of England, and European Central Bank, we investigate some of the wider macroeconomic considerations that Central Bankers will be weighing on.

Federal Reserve

Date: 14th December @ 19:00 – Current Base Rate: 4% – Expectation: Raise By 50bpts

The general market consensus is forecasting that the FOMC will raise by 50bpts, bringing the base rate to 4.5% – the highest level since October 2007. This comes after four consecutive 75bpt rate hikes as the US economy experienced inflation hitting levels not seen in over four decades.

A softer-than-expected print published on 10th November saw headline inflation ease from September’s 8.2% figure to 7.7%, as inflationary pressures on energy and food were soothed. This means that inflation in the US remains broadly in line with levels seen in January 2022 (before the Russian invasion of Ukraine sent energy, food and commodity prices spiralling). As such, investors remain upbeat on the view that the soft print will mean that the Fed are unlikely likely to deliver a further 0.75% hike.

The view that the Fed will opt for a 0.5% increase was given greater credence by Chairman Powell’s comments on 30th November when he stated that the FOMC “do not want to overtighten,” and that “the time for moderating the pace of rate increases may come as soon as the December meeting,”

Nevertheless, the primary driver of inflation within the US economy – the labour market – remains heated, meaning that the Fed will have to remain cognisant of inflationary pressures being driven from that aspect of the economy. For example, on 2nd December, Nonfarm payrolls came in well above expectations, with 263,000 jobs filled in November ahead of forecasts of 200,000. Moreover, given that the participation rate continues to remain below its pre-pandemic levels of 62%, the fact that there are 1.7 job vacancies for each unemployed person in the US means that wages last month were growing at their fastest rate in 10 months as employers compete for employees.

Markets are also speculating on whether there will be any update on the Fed’s plans vis-à-vis quantitative tightening. At the last meeting, the Fed decided to reduce their balance-sheet by $85bn over the month of October, as they actively sold bonds at a rate twice that of July. Currently the Fed’s balance sheet stands at around $9trn, equivalent to around 37.3% of their GDP.

On a longer-term view, the OECD estimates that real GDP is projected to grow by 1.8% in 2022, 0.5% in 2023 and 1.0% in 2024. Hence, while inflation will remain well above the Fed’s target rate, slowing growth will take some of the inflationary sting out of the economy as the labour market eases. With inflation continuing to be the Feds primary focus, market expectations consider that the Federal Funds Rate will peak at around 5% in Q2 2023, and that core inflation will not fall back to the Fed’s target rate of 2% until H2 2024.

Bank of England

Date: 15th December @ 12:00 – Current Base Rate: 3% – Expectation: Raise By 50bpts

The general market conviction is that the BoE will raise rates by 50bpts, bringing the base rate to 3.5%, its highest level since October 2008 when inflation stood at 5.2%.

The BoE continue to find themselves in a precarious balancing act between trying to combat double-digit inflation while ensuring that the monetary environment that they foster does not overly hinder growth. The BoE currently forecast that the UK will go into eight consecutive quarters of economic contraction, with such concerns feeding into MPC members’ reluctance to tread a more hawkish rate path. Nonetheless, inflation still continues to climb, reaching 11.1% in last month’s print as it surpassed expectations of  10.7% and hit a fresh 41-year high.

Regarding the BoE’s balance sheet, some analysts are speculating over whether Threadneedle street may ramp up quantitative tightening in order to reduce liquidity in the markets and bring down inflation. Since the start of the pandemic, the BoE increased their balance sheet by 100% as they expanded their quantitative easing programme to £895bn (just under 50% of the UK’s GDP). Currently, the BoE plan to actively reduce their balance sheet by £40bn and passively reduce it by a further £40bn over the next year. Primarily, the reduction of their balance is coming from laying off short and medium-dated debt, given Kwarteng-Truss’ destabilising impact on the 30-year gilt market. Hence, we are reminded by the fact that Threadneedle Street’s plans are greatly contingent on unforeseen political and economic events.

According to the OECD, inflation is expected to remain above 9% into early 2023 before slowly easing to 4.5% by the end of 2023 and to 2.7% by the end of 2024, and as such money markets currently expect that the BoE will achieve their terminal rate of 4.5% by 2023.

European Central Bank

Date: 15th December @ 13:15  – Current Base Rate: 2% – Expectation: Raise By 50bpts

Following two consecutive 75bpt rate hikes, Frankfurt are expected to conduct a less aggressive 50bpt rate hike as inflation shows signs of easing across the currency union.

In November, the ECB’s minutes reaffirmed how they would remain resolute in their target of bringing down inflation, even if the means by which they do so adversely hinders growth. The minutes also highlighted that a shallow recession may not be sufficiently impactful to reduce inflation, and thus in all probability monetary tightening mechanisms would need to be utilised to a greater extent.

Subsequent to the ECB’s minuets, Eurozone headline inflation showed signs of easing as it came in at 10% – some 0.4 percentage points below expectation and 0.6 percentage points below the previous month’s record print. Prices fell in 14 of the 19 eurozone’s members, as inflationary pressures eased on food and energy, leading many investors and policy makers speculating on whether peak inflation has been achieved. As such while money markets had priced in around 68bpts going into the week commencing 28th November, the softer-than-expected print saw this readjusted to some 56bpts.

On 5th December, a slump in Eurozone retail sales of 2.6% over the course of October also fed into the market conviction that the ECB would hike by 50bpts, as investors considered how falling consumer demand will alleviate some of the inflationary heat out of the single market.

As such, attention now turns to the ECB’s other monetary policy mechanism, quantitative tightening. Indeed, according to the Governing Council member Pablo Hernandez de Cos, the ECB may provide markets with an update on Frankfurt’s plans vis-à-vis its balance sheet during the December meeting. Presently, the ECB’s are yet to relinquish any of their €5trn worth of bonds, and markets are speculating on whether they may announce some passive reduction through not reinvesting in maturing securities. Currently, the ECB’s total balance sheet stands at roughly €8.76tn or 63% of GDP as the wider economy readjusts to rates being above negative territory.

Conclusion

Hence, the 24-hour period between the Fed, BoE, and ECB’s rate decision will undoubtably deliver considerable volatility across the foreign exchange market. Such volatility will also undoubtably be present in the run up to these events as markets speculate on the extent to which Central Banks will deliver further monetary tightening in an ever-changing macro-economic landscape.

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