Will central banks pause in tightening cycle?

The Reserve Bank of Australia has already started to hike again. Photo: RBA Governor Philip Lowe

>> When will the FED cut interest rates?

The Reserve Bank of Australia has already started to hike again. There is growing speculation that the Bank of Canada’s pause may last little more than three months. And then, of course, there are already question marks about the wisdom of the Fed’s decision to pause last time out. In Mr. Steve Barrow, Head of Standard Bank G10 Strategy’s view, these difficulties prevent asset prices like stocks and bonds from rallying and leave the US dollar on a slightly firmer path than we might have otherwise anticipated.

The path of inflation, the drivers of inflation and central banks’ reaction to rising inflation has been very different from anything we’ve experienced since the early 1980s. First up, inflation has risen much more than previously, secondly the drivers have come from the supply side, not demand, and lastly, central banks have been dramatically behind the curve in lifting rates.

All these things make calibrating policy very hard for the central banks and that includes any decision about pausing rate hikes. If we were to look only at the previous 20-30 years, we would generally see that inflation was more muted, was driven by rising demand, and central banks were often in front of the curve in hiking rates.

Indeed, so “good” was the perception of central bank anti-inflationary policy that inflation ended up being too low on average, not too high, and central banks like the Fed and ECB have had to respond in recent years by tweaking their monetary policy strategy with the Fed, for instance moving from a point target for inflation to an average-inflation target. During this period, it was arguably quite easy to assume that a pause in rate hikes really meant the end of rate hikes.

More than this, rate cuts were delivered not long after the peak, which is one reason why the market is still pricing rate cuts from the Fed before the end of this year. But, this current inflation cycle is materially different from the others and hence any “certainty” we might think we have that a pause really means the end of rate hikes is really standing on very shaky foundations.

The Reserve Bank of Australia has already reversed the decision it made in April to leave rates unchanged. Now, to be fair, the RBA has not always fitted this pattern of consistent rate hikes followed by a pause as we might have seen from the Fed for instance. In addition to this, the RBA explained its decision to hike because it had new estimates of far more rapid population growth that it believed could materially lift the longer-term inflation profile compared to previous projections.

>> What can the RBA's rate hikes show?

In other words, the RBA’s decision could prove an outlier rather than a sign of what might happen to others that have paused. This being said, there is more talk that the Bank of Canada could reverse the decision to pause that it made back in March. It is certainly notable that pricing in the market currently puts higher odds on another rate hike than it did when the BoC paused in March.

In the US too, the market continues to edge towards the possibility that the Fed could hike again. If the Fed does decide to do this, it will “alert” the market beforehand, although the Bank of Canada’s non-guidance stance would seem to rule out any sort of similar warning here. Right now, we are still minded to the view that the Fed, for one, is more likely to elongate the period of high rates rather than lift the fed funds target again. But that does not imply that uncertainty about the possibility of rate hikes will go away.

Economic data seems likely to continue to show that inflation is entrenched and the labour market too tight. If that’s the case, it will constrain the ability of asset prices to rally hard. In past cycles the market has become accustomed to sharp rallies in assets as US rates fall, or even as the Fed pauses and the market readies for lower rates. But this time things seem different and, as long as that’s the case, the scope for quick asset price strength and a fast decline in the dollar would seem to be limit  ed.