Why Central Banks Are Raising Rates Again

Central banks are turning more hawkish as inflation risks increase. Our Global Chief Economist and Head of Macro Research Seth Carpenter explains what that means for the Fed, ECB and Bank of Japan.

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Seth Carpenter: Welcome to Thoughts on the Market. I’m Seth Carpenter, Morgan Stanley’s Global Chief Economist and Head of Macro Research. Today, I’m going to talk about all the movement we’ve seen in central banks and how it’s changing our forecasts.

It’s Tuesday, September 22, at 10 a.m. in New York.

Over the past two weeks, our economists here at Morgan Stanley have revised their outlooks for the Fed, the ECB, and the Bank of Japan to include more rate hikes.

Each economy faces different challenges, but all three central banks have arrived at roughly the same conclusion: growth has remained remarkably resilient despite all of the shocks hitting the global economy. And renewed energy-price pressures have increased the risk that inflation proves more persistent than they had previously expected.

The clearest example—and our biggest revision here—is the Fed.

Now for much of this year, we had actually thought the Fed might avoid hiking interest rates altogether. But in addition to this increase that we just saw at the September FOMC meeting, we now expect two additional rate hikes—in December and in March that will bring the terminal rate up to 4.25 to 4.5 percent.

While Chair Warsh has highlighted the inflationary implications of higher energy and commodity prices, for me, the more important signal was the assessment that policy is not sufficiently restrictive.

So in our view, the Fed appears to be reassessing not just the inflation outlook, but the amount of restraint that is required to bring inflation sustainably back to target.

But even with all of that said, we’re still looking at this shift as more of a recalibration of policy for the Fed rather than a fundamental shift in policy. And so the market may have—just may have—overestimated how much hiking is left.

But the shift does have clear and important market implications.

Our rate strategists expect investors to pull forward additional tightening expectations in the near term, while increasingly questioning how long policy can remain at restrictive levels before growth starts to slow.

But more broadly, the Fed now appears a bit more sensitive to energy-driven inflation pressures, and that strengthens the case for a firmer dollar.

Over recent months, rising energy prices have supported the euro because investors have seen the ECB respond more aggressively than the Fed. That maybe former asymmetry could be changing.

Our foreign-exchange strategists therefore continue to favor dollar strength, particularly against the yen.

Now Europe does face a similar inflation challenge to the Fed, though through a different mechanism.

The renewed rise in natural-gas and other energy prices has led our economists to revise up their inflation forecast materially and, therefore, to add in another ECB rate hike in December.

But we have got to keep in mind that it is not energy prices all by themselves that have changed the outlook.

Economic activity in the euro area has also proven to be much more resilient than we had anticipated. And that reduces concerns that an additional modest tightening of policy would derail growth.

And so if you take it all together, the ECB is increasingly focused on preventing higher energy costs from feeding into broader inflationary dynamics.

Now Japan might seem different, but the underlying story is really surprisingly similar.

For decades, the BoJ’s challenge was generating inflation. But now policymakers are now increasingly concerned about the possibility that inflation will overshoot its target.

After the BoJ’s hike last week, we expect it to raise rates to 1.5 percent in December and then raise rates further, to about 1.75 percent, in March.

Like the Fed and the ECB, the BoJ faces an economy that has absorbed tighter financial conditions much better than had been expected.

And yet, unlike the Fed and the ECB, our strategists believe that markets have become too aggressive in pricing the eventual destination of rates. And that creates scope for expectations to be revised lower over time.

As a result, while Japanese rates may continue to rise gradually, our foreign-exchange strategists still expect a broader trend of yen weakness to emerge once temporary positioning effects fade.

So the common thread across all three of these central banks that I’ve discussed is that, while the energy shock has changed the inflation conversation, the resilience in growth has further changed the policy conversation.

And so for investors, next year is probably going to be characterized by higher policy rates and a stronger dollar than markets expected at the beginning of the year.

Well, thanks for listening. And If you enjoy the show, please leave us a review and share Thoughts on the Market with a friend or colleague today.