Dogs Chasing Their Own Tails

By Stefan Koopman, senior macro strategist at Rabobank

Dogs chasing their own tails

The Bank of England was the last in a long line of ‘advanced’ economy central banks to decide on rates. In light of all the volatility over the past two months, the 75 bps hike that lifted the Bank rate to 3.00% wasn’t out of the ordinary, even as it was Britain’s largest in 33 years. In fact, this hike was as dovish a hike this size can be. The central bank pushed back hard against previous market expectations of a 5.25% peak in the policy rates. The actual vote was split 7-1-1 too, with Ms. Dhingra voting for a more modest 50 bps rise and Ms. Tenreyro, the most dovish of the nine, even going for a 25’er. Both flagged recession risks and monetary lags as reasons why.

The central bank almost went as far as to making a mockery of their own conflicted economic forecasts, around which almost the entire the press conference centred. First of all, some £50 billion worth (c. 2% of UK GDP) of Chancellor Hunt’s forthcoming spending cuts and tax increases couldn’t be incorporated, as these will only be detailed on November 17. Secondly, Governor Bailey emphasised they have plugged in an outdated and, in their view, implausibly high forward curve into their model, which is then conditioned to spew out an extremely bearish forecast. If rates rise as high as 5.25%, which was priced only a few weeks ago and sits well above the unobservable-hence-inferred neutral rate of around 1.5%, the economy tanks and inflation follows with a lag.

The president of the ECB seems to have read a different memo. According to Ms. Lagarde, who somehow still doesn’t see a Eurozone contraction as her base case, “a recession wouldn’t be enough to tame inflation”. To which the obvious retort is: if not even a recession can tame inflation, then what the hell can!?

Back to the Bank of England. Its forecasts imply the UK is already in recession, that GDP will fall for eight quarters straight, and that economic activity will not return to its pre-pandemic level before 2026. With demand depressed for years to come, unemployment will almost double and inflation is expected to undershoot the target, falling all the way down to 0.0% in late-2025. Note that even as central bank policies are currently dictated by spot inflation, like dogs chasing their own tails, this is still the relevant policy horizon given Dhingra’s and Tenreyro’s monetary lags.

The alternative forecasts the Bank of England present in its Monetary Policy Report are based on a constant path of Bank rate at 3%, rather than on a volatile market curve. But even then, they see a sharp slowdown in growth and inflation eventually falling to below 1% y/y in late-2025. This can only mean one thing: the central bank believes the British economy is too weak to deal with a policy rate of 3%. Underlying this is a sombre view on the UK’s structural rate of growth. This is a consequence of years of subpar investment, tight labour supply and stubbornly weak productivity growth. The regular reader knows we agree with this view. We also think Chancellor Hunt’s Austerity 2.0 only makes matters worse, in particular if capital spending will be slashed too.

Governor Bailey said the MPC “will not pursue a path that will drive inflation far below target”, even as it “does not intend to keep rates constant either” (have a sip of your coffee and think about the inconsistencies with the central bank’s own modelling) and that his ‘best guess’ of the terminal rate would be closer to the constant rate curve than the current market curve. So, to sum up, Bailey sees a rate of 3% as too low, but one of 4.75% as too high and one of 5.25% as out of the question. But is it really?

This week, there has been a global debate about the current pace of interest rate hikes, the peak at which central banks decide that enough has been done, and the pivot that at some point will follow. The RBA, Norges Bank and the Bank of Canada have all slowed down. Yesterday, the Fed signalled it is looking for a slower pace, but to a higher peak, and for a longer period of time. This is a cue the ECB seemed to have waited for, even though we doubt the data already allow for a slowing of the pace already in December. The Bank of England is instead signalling it is accelerating the pace, to a lower peak, and for a shorter period of time. We don’t fully buy into this and expect that high spot inflation readings will force the Bank to raise rates by 50 bps in December and eventually to 4.75% next year.

The market wasn’t buying it either: in spite of Bailey’s explicit warnings, investors are still pricing in a peak of 4.65%, but the renewed ‘inflation insouciance’ on the part of the central bank did put some pressure the backend of the gilt curve and accelerated the slump in sterling to below 1.12. This morning, however, the dollar is handing back some of its post-Fed advances, in anticipation of the two main events of the day.

Day Ahead

German Chancellor Olaf Scholz finally meets Chinese President Xi Jinping today, a trip that has been heavily criticised by Scholz’ domestic and foreign allies (…and basically everyone else who has had some practice in delayed gratification) as a sign of deference to the increasingly authoritarian leadership in Beijing. In an op-ed for Politico, the Chancellor found the ethical flexibility to a) admit that he too sees China lurching back toward a more openly Marxist-Leninist political trajectory, but b) still reasoning that “it is precisely because ‘business as usual’ is no longer an option in these circumstances that I’m traveling to Beijing”. Again, the regular reader will again know how we look at this: after having made a strategic and, even more reprehensible, a moral miscalculation on Russia, is China really the economic buoy Germany wants to cling onto?

Tellingly, Germany’s new manufacturing orders slumped heavily in September, falling an astonishing -4.0% m/m and -10.8% y/y. The decline stemmed entirely from foreign orders (-7.0% m/m) while domestic orders increased slightly (+0.5% m/m), underlining why Scholz is going cap in (a very weak) hand to China.

It is, however, unlikely that Scholz’ visit will produce any dopamine-inducing headlines, so rest assured that traders instead set their sights on the October non-farm payrolls report. An increase of 195,000 jobs is expected, following a comparable increase of 239,000 in Wednesday’s ADP survey. The White House has been active in some expectations management too, seeing gains of around 150,000 per month in coming months. Unemployment should rise slightly to 3.6% and average hourly earnings should be up 0.3% m/m and 4.7% y/y. That is still some 1.5%-points too high for it to be consistent with 2% inflation, so there’s still a lot to be done.

The JOLTS report earlier this week showed why it may take a while before pay settlements really start to moderate. The voluntary quits rate is still elevated at 2.7%, down from 3% in the ‘Great Resignation’ of late-2021, but still well above the ‘normal’ 2.2-2.4% bandwidth. The report also showed there were still 1.9 job openings for every unemployed worker. Both the quits- and the vacancies/unemployment ratio have a good fit with measures of wage growth. The upward shift in the Beveridge curve, which shows the relationship between unemployment and openings, indicates that the US labour market may not cool in an orderly fashion, with a slowdown in employment growth predominantly leading to falling openings, but only due to a rise in unemployment. In our view, this portends a recession in 2023.

That said, Happy Friday