Central banks around the world have now given the markets a clear message — tighter policy is here to stay

George Saravelos, head of FX research at Deutsche Bank, said the major central banks had given the markets a “clear message” that “financial conditions need to stay tight.”

“We wrote at the start of 2022 that the year was all about one thing: rising real rates. Now that central banks have achieved this, the 2023 theme is different: preventing the market from doing the opposite,” Saravelos said.

“Buying risky assets on the premise of weak inflation is a contradiction in terms: the easing in financial conditions that it entails undermines the very argument of weakening inflation.”

Within that context, Saravelos said, the ECB and the Fed’s explicit shift in focus from the consumer price index (CPI) to the labor market is notable, as it implies that supply-side movements in goods are not sufficient to declare “mission accomplished.”

“The overall message for 2023 seems clear: central banks will push back on higher risky assets until the labour market starts to turn,” Saravelos concluded.

Economic outlook tweaks

The hawkish messaging from the Fed and the ECB surprised the market somewhat, even though the policy decisions themselves were in line with expectations.

Berenberg on Friday adjusted its terminal rate forecasts in accordance with the developments of the last 48 hours, adding an additional 25 basis point rate hike for the Fed in 2023, taking the peak to a range between 5% and 5.25% over the course of the first three meetings of the year.

“We still think that a decline in inflation to c3% and a rise in unemployment to well above 4.5% by the end of 2023 will eventually trigger a pivot to a less restrictive stance, but for now, the Fed clearly intends to go higher,” Berenberg Chief Economist Holger Schmieding said.

The bank also upped its projections for the ECB, which it now sees raising rates to “restrictive levels” at a steady pace for more than one meeting to come. Berenberg added a further 50 basis point move on March 16 to its existing anticipation of 50 basis points on Feb. 2. This takes the ECB’s main refinancing rate to 3.5%.

“From such a high level, however, the ECB will likely need to reduce rates again once inflation has fallen to close to 2% in 2024,” Schmieding said.

“We now look for two cuts of 25bp each in mid-2024, leaving our call for the ECB main refi rate at end-2024 unchanged at 3.0%.”

The Bank of England was slightly more dovish than the Fed and the ECB and future decisions will likely be heavily dependent on how the expected U.K. recession unfolds. However, the Monetary Policy Committee has repeatedly flagged caution over labor market tightness.

Berenberg expects an additional 25 basis point hike in February to take the bank rate to a peak of 3.75%, with 50 basis points of cuts in the second half of 2023 and a further 25 basis points by the end of 2024.

“But against a backdrop of positive surprises in recent economic data, the extra 25bp rate hikes from the Fed and the BoE do not make a material difference to our economic outlook,” Schmieding explained.

“We still expect the U.S. economy to contract by 0.1% in 2023 followed by 1.2% growth in 2024 whereas the U.K. will likely suffer a recession with a 1.1% drop in GDP in 2023 followed by a 1.8% rebound in 2024.”

For the ECB, though, Berenberg does see the extra 50 basis points expected from the ECB to have a visible impact, restraining growth most evidently in late 2023 and early 2024.

“While we leave our real GDP call for next year unchanged at -0.3%, we lower our call for the pace of economic recovery in 2024 from 2.0% to 1.8%,” Schmieding said.

He noted, however, that over the course of 2022, central banks’ forward guidance and shifts in tone have not proven themselves to be a reliable guide to future policy action.

“We see the risks to our new forecasts for the Fed and the BoE as balanced both ways, but as the winter recession in the euro zone will likely be deeper than the ECB projects, and as inflation will probably fall substantially from March onwards, we see a good chance that the ECB’s final rate increase in March 2023 will be by 25bp rather than 50bp,” he said.