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Friday 10th December 2021
Hi Friend,
Friday Forward Guidance ...
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| | The Saturday Economist Friday Forward Guidance ...
This is our Friday Forward Guidance for Friday 10th December. Every week we update our scenario forecasts for base rates in the U.S. UK and Europe over a three year period. We also include our expectations for inflation, as an input to the central bank reaction function, in the Saturday Economist updates.
Our rate scenarios are unchanged this week. Sterling closed down as markets began to realize there would be no rate rise in December! In the US, markets shrugged off the risks of the Omicron variant. In the UK, two speeches this week from MPC members added to the confusion, on central bank policy. In Europe, western leaders plan reprisals if Russia invades Ukraine. Nord stream 2 would be disconnected. Gas supplies would be cut off from the east. Great plan for Uncle Sam.
When it comes to understanding market moves, "Any explanation is better than none" (Nietzsche).
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| | Fed Funds Rate ...
Former Treasury Secretary, Larry Summers suggested the Fed should signal four rate hikes in 2022 to restore the bank's credibility in the fight against inflation.
High inflation and low unemployment prompted the Powell pivot. The Fed is expected to accelerate asset tapering. Officials are preparing plans to end the bond buying process as early as March. This would open up the option to raise rates in the Spring next year rather than wait until the second half of the year.
For the moment, we attach a higher probability to conclusion of the asset purchase program by the end of Q2 next year. This would leave the way open to two base rate hikes in the second half of the year, rising to 2.50% by the end of 2025. This is our "We are leaving Planet ZIRP" scenario. The earlier move would offer symmetry with the UK direction of travel. US rates would end the year at 0.75%.
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| Fed Funds Rate 2021 2022 2023 2024 2025 Long Run Rate
Q4 0.10% 0.50% 1.00% 1.75% 2.50% 3.5%
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| | Bank Base Rate...
Two speeches from MPC members this week added to the confusion on central bank policy. Michael Saunders (hawk) suggested any rate rise could be delayed until further implications of the Omicron crisis have been assessed.
Deputy Governor Ben Broadbent introduced the "No point shutting the stable door" reaction function. He predicted inflation will rise to over 5% by Spring but he expects cost pressures to ease before any increase in interest rates would impact on demand and price levels.
Markets expect Omicron Plan B to delay any rate rise before the end of the year. As we said last week, there has been no rate rise in December for over fifty years. We expect the first rate rise, late into Q1 next year, with two further rate rises possible before the end of the year, rising to 2.50% by the end of 2025.
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| Bank Base Rate 2021 2022 2023 2024 2025 Long Run Rate
Q4 0.10% 0.75% 1.50% 1.75% 2.50% 3.50%
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| | Euro Base Rate...
Christine Lagarde, President of the the EU Central Bank had suggested European rates could stay on hold through 2022. The ECB announced plans to terminate net purchases under PEPP, the Pandemic Emergency Purchase Plan, once the crisis was over, but in any case not before the end of March next year. Roll over funds would be re invested until the end of 2023 at the earliest.
The governing council had decided to increase the initial €750 billion for the PEPP by €600 billion in June 2020 and €500 billion in December for a total of €1,850 billion. Given concerns about growth, the ECB may consider some extension of the rollover period beyond the 2023 horizon.
We present below the implied EU bank scenario. If our expectations for US and UK rates hold, we would Euro rates could close at 0.50% by the end of the year to avoid significant pressure on the Euro.
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| ECB Base Rate 2021 2022 2023 2024 2025 Long Run Rate
Q4 0.00% 0.00% 0.50% 0.75% 2.50% 3.50%
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| | | This is the table of scenario comparisons. We would normally expect UK rates to lag not lead the US pattern. EU rates would follow the US/UK lead. Inflation may subside sooner than expected, central banks may worry about the shock to growth. The escape from Planet ZIRP may be aborted. This is a scenario not the plan.
Our modified Taylor rule suggests the UK central bank is behind the curve on rate hikes. In our modified Taylor rule we model base rates as a function of inflation variance from target and the output gap relative to trend growth. The implication is base rates should close the year at 1.25% in 2021, rising to 1.50% by the end of 2022. This is a benchmark not a forecast!
We model the long run rate at 3.50%. The Fed Blue dot projections assume 2.50% as the perceived long run rate. In the UK, prior to the Great Financial Crash [2000 - 2008] the average inflation rate was 2.0%, the average UK bank rate was 4.50%. Ten year bond yields averaged 4.50%.
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| | That's all for this week's Friday Forward Guidance. Don't miss the Saturday Economist Out Tomorrow ... and our market updates on Monday ...
John
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© 2021 John Ashcroft, Economics, Strategy and Financial Markets, experience worth sharing.
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