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Friday 7th January 2022
Hi Friend,
Friday Forward Guidance ...
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| | The Saturday Economist Friday Forward Guidance ...
This is our Friday Forward Guidance for Friday 7th January. 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 outlooks are pretty much unchanged from the December outlook. The minutes of the December Fed meeting were released on Wednesday. The word "transitory" has transitioned into history. Fed "tapering" will end in March. The first Fed rate hike is expected by the end of the first quarter this year.
The year is set for rate hikes in the U.S. and the U.K. Rates are set to ease in China and Russia. Europe and Japan are expected to hold rates at current levels through the year. The world is polarizing into separate spheres of monetary influence with implications for currency stability.
Asian central banks will be dragged, over the medium term, into the orbit of the Peoples Bank of China. The ECB may have to respond to Dollar strength to support Euro weakness.
US markets closed down. Sterling and the Dollar moved higher against the Euro. Bond yields in the U.S. and U.K. moved up twenty basis points. US Ten Year yields at 1.74 puts our target of 2.00 into range with implications for UK gilts.
When it comes to understanding market moves, "Any explanation is better than none" (Nietzsche).
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| | Fed Funds Rate ...
The FOMC minutes were released this week. Elevated inflation had persisted longer than anticipated. Members agreed it was important to remove the reference to "transitory factors" affecting inflation. Supply and demand imbalances have continued to contribute to elevated inflation. Back to demand pull and cost push, tighter monetary policy may have a rôle to play after all.
Markets now attach a 40% probability to four rate increases this year. March, June and November should be penciled in. A fourth hike in December looks to be too aggressive for the moment.
We
attach a 100% probability to conclusion of the asset purchase program
by the middle of Q1 next year. This would leave the way open to
three base rate hikes from end of Q1 onward, rising to 2.50% by the end of
2025. The earlier move would offer symmetry with the UK direction of travel.
US rates would end the year at 0.85%. The projections are in line with the FOMC December
Blue Dot Plot. This is our "We are leaving Planet ZIRP" scenario.
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| Fed Funds Rate 2021 2022 2023 2024 2025 Long Run Rate
Q4 0.10% 0.85% 1.50% 2.00% 2.50% 3.50%
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| | Bank Base Rate...
CPI inflation increased to 5.1% in November. The Bank expects inflation
to peak at over 6% in April before easing towards the end of the year.
In the December meeting, the MPC voted 8 - 1 to
increase base rates by 15 basis points. We expect two further rate rises
in 2022. The first, in tandem with the Fed in March. February, is the current bookies favourite.
The market-implied path for Bank Rate hits 1.1% by the end of 2022. Bloomberg forecasts base rates at 0.75% by the end of the year, rising to 1.00% by the end of 2023. We assume the pattern of rate hikes, will hold in line with US Fed
policy, to close at 0.75% in the final quarter. The full 100 basis points may be too much of a stretch. We expect more to follow in 2023, pushing to 1.50 at close.
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| Bank Base Rate 2021 2022 2023 2024 2025 Long Run Rate
Q4 0.25% 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. Inflation in the euro area is expected to fall back below the 2% goal in 2023 and stay there in 2024, despite strong economic growth.
President Christine Lagarde has said rate increases are still “very unlikely” this year but she is prepared to change her mind should consumer prices rise more quickly than expected.
We
continue to present the implied EU bank scenario. Some governing council members have started to warn about the upside risks to inflation. If our expectations for US
and UK rates hold, we would Euro rates could close at 0.50% by the end
of 2022 at least, 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. Concerns over the Omicron variant may increase. The escape from Planet ZIRP could 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 and by 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 ...
John
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