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It’s all about interest rates in the financial markets this week.
Last week, the central bank in Poland made a surprisingly large cut in the key interest rate. Not long ago, an unchanged key interest rate was signaled. In contrast, the strategy of many other central banks is far more prudent.
A dove
The central bank in Poland (NBP) surprised the markets last week with a sharp cut in the key interest rate. The interest rate was cut by 0.75 percentage points to 6%. Analysts’ estimates were for either an unchanged rate or a 0.25 percentage point cut. Not long ago, the central bank was signaling that it would not consider cutting rates until consumer price inflation fell into the single digits. Admittedly, in August inflation was “only” 10.1% year-on-year. However, the guidance on market expectations (forward guidance) also included that key interest rates would probably be lowered in small steps. The central bank justified the big step by saying that the first rate cut should have taken place three months ago. The economic argument was that weaker-than-expected demand would also lead to a faster decline in inflation. In fact, GDP contracted by 3.7% quarter-on-quarter and 0.5% year-on-year in Q2. The upcoming parliamentary elections in October may also have entered into the considerations.
Several hawks
In contrast, the central bank in Australia left the key interest rate unchanged at 4.1%, as expected. At the same time, the inflation-hawkish tone was maintained. Key phrase: “Some further tightening of monetary policy may be required.” The Bank of Canada also left the key interest rate unchanged as expected (at 5%). Justification: The best way to address the risks of too much and too little policy rate hikes is to leave the rate unchanged, it said. However, the description of inflation still sounds concerned: “The longer high inflation persists, the greater the risk that high inflation becomes entrenched.”
Stagflation in the Eurozone
The euro zone is in a difficult situation. While inflation is falling only slowly, the economy is stagnating. In August, consumer price inflation excluding food and energy – the traditional core rate – was still 5.3% year-on-year. Gross domestic product grew only very slightly in the second quarter (0.1% quarter-on-quarter and 0.5% year-on-year). Credit volumes have already been stagnating since summer 2022. The important survey-based indicators (European Commission economic confidence, purchasing managers’ indices) have already fallen to such low levels that the model-based estimate for GDP in the third quarter (the nowcast) suggests a contraction.
Chart legend: According to a forecast by the International Monetary Fund, global inflation should weaken significantly in the next few years.
Legal note:
Prognoses are no reliable indicator for future performance.
Three criteria for the ECB monetary policy
In the design for monetary policy, the ECB applies three criteria:
– inflation dynamics (disappointingly slow decline),
– inflation forecasts (are above the 2% target)
– impact of monetary policy.
With the latter, the central bank could argue a pause. President Lagarde has underlined that the central bank will proceed in a data-dependent manner (little confidence in forecasts). What is uncertain is how much influence the central bank has had in slowing the economy. That is, there is considerable uncertainty about how restrictive monetary policy actually is.
Weaker demand
In theory, however, weakening demand reduces the risk of a wage-price spiral. The pricing power of firms declines, and a weaker labor market reduces the bargaining power of workers. Separately, more frequent supply-side shocks caused by deteriorations on the geopolitical front could keep inflation at too high a level, as President Lagarde opined in a recent speech.
No interest rate hike
For the meeting of the European Central Bank next Thursday, the average of analysts does not expect any change in interest rates (deposit facility: 3.75%, main refinancing rate: 4.25%). Market prices also reflect an unchanged interest rate. The numerous speeches by Council members in recent weeks have been mixed. A key rate hike in a stagnant economic environment would certainly be an opportunity to underline the commitment to achieving the inflation target.
However, amid the tension between deflationary pressures in China (producer prices in August: minus 3.0% year-on-year), recession risks in the euro zone and strong growth in the USA (Atlanta Fed nowcast: annualized 5.6% in the third quarter), the European Central Bank is likely to adopt a wait-and-see approach and not raise key interest rates.
The lagged effect of monetary tightening on economic growth and inflation is variable in terms of both duration and magnitude (long and variable lags). Put more simply, forecasts do not work satisfactorily, which is why the central bank looks to published economic data. Now growth has weakened. Although the effect on inflation is uncertain, there is scope for a wait-and-see stance with a hawkish tone on inflation.
For a glossary of technical terms, please visit this link: Fund Glossary | Erste Asset Management