Central banks struggle with changing facts

All the four big central banks met in the past week. As expected, none shifted interest rates. My main analysis today will look at how the Federal Reserve, European Central Bank, Bank of England and Bank of Japan responded to changed economic facts. It is early days for the BoJ but none of the other big beasts landed their statements well with financial markets. Could they have done better to get their point across? Email me: chris.giles@ft.com

This is the last newsletter of this year. On January 2, my colleague Claire Jones, who is currently covering the Federal Reserve, will be substituting for me.

When the facts change, I change my mind. What do you do, sir?

The economic facts have changed significantly since the leading central banks last met to set monetary policy in late October or early November. How much did they change their minds? And what were the consequences?

Everyone tends to agree in theory with this phrase attributed to John Maynard Keynes. But today’s newsletter will look at how difficult some central banks have found it to follow the advice and how others failed to execute the pivot they desired.

The Fed: ‘We changed, but really not that much’

Following encouraging inflation data and a cooling labour market, the Fed performed a full pivot last Wednesday, switching from a tightening bias to one that foresees rate cuts in 2024. The central bank’s summary of economic projections showed Federal Open Market Committee members believed they could now cut interest rates by 0.75 percentage points in 2024 to a range of 4.5 to 4.75 per cent without triggering a renewed bout of inflation. As the chart shows, the Fed removed its hawkish tendency from September and returned to roughly the view it had in July.

Fed chair Jay Powell gave a notably dovish press conference in which he revealed that some FOMC members were revising their dots of expected interest rates and their forecasts up to the middle of the morning in US time on Wednesday before the announcement. This is impressively up to date.

Sadly, for the Fed, going the full Keynes did not achieve the financial market response it hoped. Before the meeting, forward market prices were for the Fed’s policy rate to fall to around 4.25 per cent in 2024, further than the FOMC’s projections. Instead of taking on board the Fed’s more cautious predictions of its ability to cut rates, markets assumed the Fed’s pivot showed it was now on a rapid rate-cutting journey. They doubled down on their bets for cuts and by the end of the week, market expectations were for US rates to fall to 3.75 to 4 per cent by the end of 2024.

How do we know the Fed was caught out by these market reactions? It rapidly sent out the chairs of the New York, Atlanta and Cleveland regional Feds, John Williams, Raphael Bostic and Loretta Mester to hose down the exuberance. These words were then promptly undermined by Chicago Fed’s Austan Goolsbee who did not rule out a rate cut as soon as March when speaking to the Wall Street Journal.

For the Fed, its communication last week was not its finest. It did the right thing in responding to the news but had a bad outcome. Forecasts and words sought to temper enthusiasm with a realistic outlook, but the result only encouraged the bulls.

The ECB: ‘You have to wait — we’re out of date’

If the Fed had a difficult time last week, so did the ECB. Eurozone economic data has been weak and inflation has been dropping like a stone. But these facts did not really appear in the ECB’s staff forecasts because the central bank has a cut off for new data set three weeks before the interest rate meeting — in this case November 23.

Compared with its projections in September, the ECB’s growth numbers were revised slightly down alongside lower inflation. The scale of these forecast changes was not large, and as with the Fed, these outcomes were achieved with assumptions of slightly lower interest rates. For 2025, the outcomes were conditioned on an interest rate of 2.8 per cent compared with 3.1 per cent in the September forecasts.

What was odd in the ECB’s forecasts was a staff view (not explained) that labour costs would remain stubbornly high, leaving the underlying core inflation forecast higher by the middle of 2024 than it was in the September even though recent core inflation data has been good. The November 23 cut off also prevented the ECB staff taking account of large falls in oil and natural gas prices. Natural gas prices in Europe for 2024 are down almost 25 per cent, for example (see chart).

These unexplained and out-of-date forecasts allowed Christine Lagarde, ECB president, to insist that little had changed in its outlook and that policy rates still needed to remain at “sufficiently restrictive levels for as long as necessary”. But the inability of the ECB to update its forecasts as the facts change meant that Lagarde’s claims in her press conference that the ECB would be “data dependent” were not credible because the data underpinning decisions was problematically out of date.

Not surprisingly, financial markets did not lend much credibility to the central bank’s forecasts or Lagarde’s words and ended the week expecting ECB interest rates to fall even further during 2024 from the current 4 per cent rate to 2.5 per cent. It was not a good week for ECB credibility.

BoE: ‘La la la, we’re not listening’

The BoE did not produce new forecasts this month because it works to a different schedule. It did publish extensive minutes of its meeting which left the interest rate at 5.25 per cent on a six to three vote with the minority still favouring a quarter-point hike.

I would love to know other people’s opinion on this set of Monetary Policy Committee minutes because I fear I am about to sound a bit dismissive. It is fine for the MPC to decide to hold rates and correct for it to worry that the UK has potentially worse inflationary dynamics than the US or eurozone, but everything in the committee’s reasoning suggested a group of people inconvenienced and annoyed by changing facts.

Inflation was better than the MPC had expected, so were wage increases, so were oil and gas prices, but all of these significant facts were summarily dismissed in the minutes. The MPC noted these changes (unlike the ECB) and then ignored them. The following quotes give a sense of how odd the minutes are. In paragraph six, the MPC noted big changes in energy prices since it last met in November.

Since the MPC’s November meeting and despite the continuing conflict in the Middle East, the Brent spot oil price had fallen by 17 per cent, to around $75 per barrel . . . European wholesale gas spot and near-term futures prices had fallen by nearly 30 per cent.

But instead of talking about how these real changes would affect the outlook for wages and inflation, the MPC chose instead to analyse a wholly fictitious alternative scenario and discuss this in paragraph nine.

There was also a risk that developments in the Middle East could lead to a renewed rise in energy, and potentially other traded goods, prices. Such a shock would push inflation higher once again, and could interact with inflation expectations and lead to second-round effects.

The unwillingness of the BoE even to acknowledge that changing facts might lead the MPC to have to change its mind on the economic outlook in February (it will), puts it again behind the curve.

BoJ: ‘Nothing has changed’

No one expected the BoJ to end its negative interest rate policy at the December meeting but quite a few thought a policy change was possible in January. That would mean raising the interest rate from -0.1 per cent or ending yield curve control. After the meeting and press conference by governor Kazuo Ueda, analysts scaled back even these expectations. The yen fell.

Ueda said there had not been enough evidence of a positive wage price spiral to change policy and he was not expecting “much new data to come in during the period [before the January meeting]”. All hopes are on real wages rising as price inflation moderates and a positive dynamic occurring. Flurries of excitement that things were changing in Japan a little more quickly, were premature.

What I’ve been reading and watching

• Over at Unhedged, Robert Armstrong interviewed Larry Summers of Harvard University. He gives a coherent account of why the Fed needs to be careful about interest rate cuts, alongside a regrettable call for central bankers to become Delphic again with language

• BoE officials published useful research showing households were already cutting expenditure ahead of upward resets of their mortgage rates suggesting faster pass through of higher interest rates

• The Dutch central bank has produced simulations showing that commercial banks could easily withstand potentially radical regulations to boost nature and biodiversity. It has caused a bit of controversy and is written up by Banking Risk and Regulation, a news service published by FT Specialist

• The FT has run numerous stories of central bankers having to clarify what their statements means. For a flavour, here are one each from the Fed, the ECB and the BoE

A chart that matters

The FT reported on rapidly rising bankruptcies on Monday. Importantly, levels of company failures are still low and this is a demonstration of why it is always important to look at both levels and changes.