Are we at or near peak rates?

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The Federal Reserve (Fed) and European Central Bank (ECB) last week pushed their policy rates up by a further 25 basis points. The market expects the Bank of England to follow suit at its meeting this Thursday. Will these interest rates prove to be the peak?

Neither the Fed nor the ECB stated definitively that their job is done. Their respective communications made clear that they are now dependent on the incoming data.

I suspect their attention will be focused on four areas: credit demand and supply, Purchasing Managers’ Index (PMI) readings, employment and headline inflation. Each of these capture a different stage of the transmission of monetary policy.

The most forward looking data is that from the large banks who report on changing patterns in the supply and demand for credit. As you can see from Chart 1, higher interest rates are certainly deterring both households and corporates from taking on additional loans, which is likely to slow both consumer and business spending further in the coming months.

While this data provides some indication of demand in the future, the PMI surveys are the best barometer of today’s activity. On this measure, the manufacturing sector has been very weak in all regions for some time, most likely because consumers had overspent on goods relative to services in the pandemic and manufacturing companies were at the forefront of commodity price pressures.

Until the most recent print, weakness in manufacturing had been offset by extraordinary strength in services as consumers were still busy recouping the lost experiences in the pandemic. However the data for Chart 2 shows that the service sector has also lost momentum.?

Within the PMIs, we should also keep an eye on the metric of prices charged (Chart 3). Weaker activity is reducing firms’ intentions to raise prices but we are still not at levels that we saw before the pandemic.

Employment reports will also be important. To be confident that underlying inflationary pressures are truly moderating, central banks will need confirmation that wage growth is easing. So far, employment reports in all regions have remained remarkably strong, even in manufacturing where activity has been weak. It seems that firms are opting to hoard labour, which is perhaps unsurprising given the difficulties they faced in finding staff after the pandemic. Unemployment is still near record lows in most regions and wage growth may have peaked but is still sitting at levels that, given weak productivity, do not appear consistent with a 2% inflation target, particularly in the UK. If anything is going to keep central banks hawkish, it will likely be the labour market.

Finally, headline inflation numbers will remain critical. Economists might argue that looking at current inflation (or employment for that matter) would be a mistake akin to driving while looking in the rear view mirror. However, that isn’t true in periods of high and sustained inflation, because consistently high prints risk dislodging inflation expectations. In other words, households and businesses get used to hearing about high inflation, see it as a new normal, and become accustomed to continued prices increases.

Headline inflation has already fallen to less concerning levels in the US, largely as a result of the base effects of energy prices. In Europe and the UK, these base effects are yet to make a significant impact. This is particularly important for understanding why UK inflation is still so elevated; the energy contribution to inflation is currently -1.6 percentage points in the US, -0.6 percentage points in the eurozone and +0.2 percentage points in the UK. Base effects will help bring headline inflation down further in Europe, allowing central banks to argue that they are winning their inflation fight.

Where does that leave us? We suspect that the Fed is now done at the current target rate of 5.25-5.50%. We think the ECB will need a little more convincing and therefore see the deposit rate reaching 4% in September. The UK is the hardest to assess with the Bank of England fully aware of the acute strain higher interest rates are imposing on certain mortgage holders but at the same time observing consistently strong wage growth. We see the UK Bank Rate peaking at 5.5% in October.

While this expectation is broadly in line with current market pricing of peak rates, albeit a little lower than UK pricing, I am less convinced that central banks will be quick to pivot to cutting rates in the way the market is anticipating (Chart 4). Whether interest rates will be higher for longer is a question I’ll tackle next month.?

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