Central Bank Guidance Has Become a Messy Affair

Central Banks in a Tough Spot

Major Central banks around the world have embarked upon an aggressive monetary tightening path, in order bring down rampant inflation, which is largely attributed to the war in Ukraine, soaring energy prices and supply chain disruptions.

All the above factors however impede economic activity and create fears of recession, making the pursuit of further aggressive rate hikes more difficult. This is a challenging landscape to navigate that is reflected to their communications and forward guidance, which has become messy.

US Federal Reserve

The US central bank had been viewing high inflation as transitory for a long time, but was forced to a U-turn late last year, making this part its mandate the top priority. In pursuit of this, it started hiking rates back in March, with two back-to-back historically large 0.75% moves lately. Interest rates now stand at 2.25%-2.5%, which is the highest level since December 2018 an in the range of neutral, as per Chair Powell. ^[1]

Inflation has not shown any signs of easing, but on the other hand, the US economy posted two-straight quarters of contraction – the technical definition of a contraction, although there is much debate around it.

The Fed has generally done a very good job in clearly communicating its intentions and providing explicit forward guidance - perhaps too explicit in some cases. As the above factors weigh and after Mr Powell reneging on his 50 bps signaling, these days are now over.

At July's latest policy meeting, the bank shifted to a meeting-by-meeting approach and touted its data dependence, refraining from offering guidance around its next move in September.

Chair Powell reiterated the bank's commitment to fight inflation, noted that rates need to rise further to to "at least to a moderately restrictive level" and did not rule out another unusually large rate-hike.

On the other hand, he added that it "likely will become appropriate to slow the pace of increases", in a reference that grabbed headlines and which hints towards a potentially less aggressive Fed ahead.

Reserve Bank of Australia

The Australian central bank began its rate-hike cycle with a delay compared to its counterparts, but has increased at a very rapid pace, with three consecutive 50 basis points moves and four in a row in total.

This marks the longest tightening streak since at least 1990 that brought rates to 1.85% after this week's decsion, the highest level in six years. The RBA had the luxury to implement such an aggressive plan, since the Australian economy has been remarkable resilient and the labor market is very strong.

However, economic activity is expected to slow and the central bank downgraded today its GDP forecasts to 3.25% by the end of this year (from 4.25% previously) and to 1.75% by end of 2023 and 2024 (from 2% previously). ^[2]

Officials repeated that further steps in normalizing policy are required in the upcoming months, however they now added that this "is not on a pre-set path", rendering their guidance softer and more unclear. ^[3]

Bank of England

The cost of living has skyrocketed in the UK, since CPI Inflation hit 9.4% in June and the Bank of England expects it increase further. It upgraded its forecast on Thursday, now seeing inflation exceeding 13% in fourth quarter, from the around 11% previously projected. ^[4]. Officials offered more gloom, as they warned of a recession from the next quarter that will last until the end of 2023.

The BoE started hiking rates in December, but had been limited to no more than 0.25% adjustments, an approach that has clearly failed to dent inflationary pressures. Going into this week's policy meeting, markets had come to expect a break with convention and the central bank delivered with a 50 basis points increase, the largest in twenty-seven years.

However, the BoE is known for miscommunicating its intentions, while the policy statements are often baffling and perplexed, in contrast with its major peers. The last one was no exception, as officials maintained their pledge to "act forcefully" if required, which had been added in the previous statement and led to this week's outsized mover.

At the same time though, they added a less-hawkish spin to it, now saying that "policy is not on a pre-set path" - echoing the Reserve Bank of Australia. During his press conference, Mr Bailey was rather vague around the next moves, saying that "all options are on the table" for September, noting the importance of moving away from a system of predictive forward guidance. ^[5]

He then went on and complicated things further on BBC, warning that policy makers "will have to raise rates even higher" than they would otherwise do, if inflation becomes more embedded. ^[6]

European Central Bank

The European economy is far more exposed to the economic fallout of the war in Ukraine and highly depended on Russian gas and oil. Supply through the Nord Stream 1 was halted for maintenance for a 10-day period recently and there was reduced flow thereafter, aggravating fears that the Kremlin will completely close the taps.

Based on this, markets see prospects of a recession in the Old Continent, although these concerns may be overstretched. Despite worrying signs, the European economy has shown resilience, having grown by a healthy 4% in the second quarter.

Similar to other major economies, Eurozone inflation runs rampant, with the latest preliminary figures showing that the Consumer Price Index rose 8.9% in July.

This drove the European Central Bank to a rate lift-off last month, way later than its major counterparts. Officials had laid out a clear plan to start with an 0.25% move and potentially go bigger afterwards. However, they went against that and delivered a more aggressive 50 basis points hike, taking rates out of negative territory. ^[7]

After this unexpected and outsized adjustment, the previously communicated forward guidance was thrown out of the window. At her press conference, MS Lagarde said the guidance that the guidance which existed for September is "no longer applicable". ^[8]

Adding to the perplexity, she noted that the aggressive hike does not change the "ultimate point of arrival" - although she did not say what that is - and that "we are accelerating the exit". This was viewed, largely as dovish commentary and a sign that such an outsized move won't be repeated.

However, Ms Lagarde tried to regain control of the narrative and shift focus back on the bank's resolve to fight inflation. In a clearly more hawkish tone, she wrote that the ECB will keep raising rates "for as long as necessary" in order to bring inflation down. ^[9]

Unclear Guidance

It is clear that the monetary policy environment has become extremely hard to navigate, as sky-high inflation and prospects of economic downturn pull banks in different directions.

The aforementioned central banks, so far remain resolute in bringing inflation back down towards target and have generally hinted to more tightening ahead. On the other hand, most of them have already raised rates significantly and approach their stated goals, which along with recession fears, may limit their ability to maintain the tightening pace.

Given the above factors and failures to abide by stated hike intentions, it is clear that officials don't want to put themselves in the corner. As such, they have either abandoned forward guidance, or made it more vague.

Despite the recent somewhat softer rhetoric, central banks will have a hard time deviating from their aggressive tightening paths, if inflation does not begin to come down, which increases risks of a hard landing.