What should you know about the FED's message?

FED's upcoming tightening cycle could be more volatile and unpredictable than the last cycle.

This seems a reasonable bet given the economic situation, but what does it say about how other central banks should set their own policy?

It seems to us that there are two main aspects to this question. The first concerns the extent to which other countries face similar economic issues to the US and hence might need to run their own tightening strategy in a similarly less predictable and more volatile way. The second issue is whether some central banks might have to undertake more tightening if the Fed is in this sort of mode, rather than the steady and predictable tightening mode that we saw in the last cycle.

On the first of these we do feel that, while inflation has gone up in just about all countries, and often to multi-decade highs, the US is still in a pretty unique situation. For a start, the degree and type of fiscal policy easing we saw in the US through the pandemic was generally much larger and more direct that we saw in other countries. As a result, pent-up demand seems stronger and that’s creating more inflation risk. And then there’s the situation with the labour market which, as Powell stressed, is unusual in many ways with large numbers quitting the labour market at the same time as vacancies are soaring. Labour markets have been dislocated in many countries by the pandemic, but the US has been affected more than most.

As far as we can tell the UK is probably the one that’s in the closest predicament to the US and hence it is here where monetary tightening could prove similarly volatile, and possibly quite dramatic. UK fiscal easing has been aggressive and labour market tightness is similar to the US. In fact, if you look at job vacancies you will see that current vacancies in the UK are 59% higher than pre-pandemic levels, compared to 47% in the US. The Bank of England has already surprised the market in its last two policy meetings by refusing to hike in November and then delivering a rate rise in December. So even before Powell spoke it looked as if the UK rate cycle could prove a bit of a rollercoaster ride for the market and now it looks as if the Fed and Bank of England will be vying for the crown of least predictable policymaker. In general, our forecasts for UK base rate hikes track those we expect the Fed to make very closely. That’s because we think the UK and US will need to undertake a similar level of policy tightening, unlike the ECB, for instance, which is likely to need less. Should the BoE and Fed broadly match each other when it comes to rate hikes, we may find that sterling resists some, or all, of the possible dollar strength resulting from higher rates.

Other currencies might not be so lucky and that might force a faster or more aggressive pace of policy tightening among other central banks, perhaps especially those in emerging markets where dollar debt is prevalent. While this is undoubtedly a risk, we would not go overboard on this possibility. For the most part we believe that a less predictable, and probably more aggressive Fed tightening cycle will not force others to go at a faster pace. A number of central banks have already accumulated some capital in this regard as they have started to lift rates ahead of the Fed.

In addition, as we’ve mentioned before, we think the Fed is in a pretty unique predicament when it comes to inflation risks and hence if it acts quickly it will be hard to levy the charge that other central banks are necessarily falling behind the curve. The exception, as we’ve mentioned, might be the UK and hence we do think it is important here that the BoE keeps up with, or even stays ahead of the Fed on rate hikes.