U.S. Federal Reserve Chair Jerome Powell says the rate must still go higher, albeit at a slower pace than last year, to vanquish inflation.JONATHAN ERNST/Reuters
As interest rates approach their peak, an intriguing stand-off has emerged between North America’s major central banks and financial markets.
The U.S. Federal Reserve and Bank of Canada seem determined not to allow their gaze to drift to the future. The financial markets are already there. And each seems increasingly determined to sway the thinking of the other.
The difference of viewpoint was apparent in the Fed’s rate announcement and news conference Wednesday, as the bank raised its policy rate by another quarter of a percentage point, to a range of 4.5 per cent to 4.75 per cent.
Fed Chair Jay Powell insisted that the rate must still go higher, albeit at a slower pace than last year, to vanquish inflation. He won’t think about halting rate hikes yet, let alone entertain the notion of when the Fed might actually start cutting rates from their highest levels in more than 15 years.
“It would be very premature to declare victory,” he said.
Yet the financial markets have priced in the start of rate cuts by fall, and based on the market action Wednesday afternoon, Mr. Powell’s tough talk did nothing to dissuade them. Not only do the markets not share the Fed’s caution about declaring success in reversing inflation, they’ve moved past it to the next battle – against an impending recession.
And it seems the more markets are willing to talk about the timing of rate cuts, the more central bank leaders are pushing back with their “hey, not so fast” rhetoric.
We got a similar tone from the Bank of Canada last week, after the bank raised its policy rate to 4.5 per cent while signalling that it is prepared to pause rate increases – though not, it hastened to add, necessarily stop them.
“We’re talking about a pause … a period to allow us to assess whether we’ve raised interest rates enough to get inflation back to target,” Mr. Macklem told reporters. “We don’t want to underdo it, and then inflation stalls on the way down.”
“I think it’s far too early to be talking about cuts,” he said. In fact, he said it three times in the space of about half an hour.
It’s much more than a matter of principle for the central banks. The view expressed by the markets manifests itself in lower bond yields, which translate into lower borrowing costs. The yield on Canada’s five-year government bond has fallen nearly half a percentage point in the past month, despite a central bank policy stand that is still tilted upward (if, now, only slightly).
The longer those lower yields persist, the more they effectively work against the central banks’ efforts to slow the economy – and, hence, inflation – through the steep increases in the policy rate. They would rather have the markets aligned more closely with the banks’ stated view that high rates could still inch higher, and certainly could be around for a while.
But the markets are increasingly tuning out. They see inflation on a decidedly downward trajectory that looks all but certain to gain steam over the next few months, and a very possible recession on the horizon. They’re preparing for a reversal of course in interest rates, even if the central banks claim they’re not.
“Moving forward, markets are going to largely shrug off the Fed’s hawkish tones and rate rises,” said Nigel Green, chief executive of financial consultancy deVere Group, in a commentary Wednesday.
“The Fed’s rhetoric doesn’t appear to be changing, despite the data, and the markets are aware of this.”
Based on the market reaction to the Fed’s message Wednesday, it doesn’t look like the threat of more rate hikes is having the desired effect. The market pricing of rate cuts by fall actually increased a bit after Mr. Powell’s news conference. The thing is, the more central banks are willing to raise rates, the more likelihood that they’ll tip the economy into a significant recession – which actually strengthens the case for rate cuts.
The Bank of Canada’s position at this point looks somewhat less rigid than that of the Fed; the Canadian central bank did, after all, state clearly that it intends to pause further hikes at its next decision in March, provided the economy unfolds largely as it expected between now and then. Based on Mr. Powell’s comments to reporters, he and his Fed colleagues didn’t even seriously discuss a pause.
This represents a divergence between the two central banks, which have been raising rates essentially in parallel since last March. It appears likely that the Bank of Canada will declare a top to its rate cycle a bit sooner, and a bit lower, than the Fed.
That’s not unreasonable, given that the Canadian inflation rate peaked considerably lower than the U.S. rate, and that Canada’s higher household debt levels leave its economy more exposed to the impact of rate increases. Still, it raises an important question about just how out of step the Fed and the Bank of Canada will become.
For this, too, the central banks and the markets will need to start speaking a common language on rate cuts. As long as they are talking over each other, it may be entertaining, but it’s neither constructive nor informative.