The main focus has been monetary policy, and this looks like remaining the dominant theme through the second quarter, too. Western economies, driven by the US, are witnessing the end of cheap money, with interest rates rising and previous asset purchases by central banks or quantitative easing being reversed. This has exposed cracks in economies and in the banking sector and led to stressful periods in the financial markets.
Challenges for central banks – and the banking sector
Central banks began the quarter with a difficult challenge, to get the balance right between tightening to combat inflation, while not hitting economic growth as a consequence of tightening too much. An underlying issue for the markets has been the extent to which central banks were prepared to trigger a recession to curb inflation.
This was especially a problem for the US Federal Reserve (the Fed) which has a dual mandate to achieve “stable prices” and “maximum employment”, whereas the Bank of England’s is a 2% inflation target. By the end of the quarter, in addition, central banks were having to balance problems in the banking sector.
Banking sector problems posed the challenge to avoid “financial dominance”, where monetary policy decisions would be dominated by banking issues. In the end, the Fed, BOE and European Central Bank all hiked policy rates, despite the banking crisis, and retained a bias to tighten. Also, the Fed tried to balance this by providing ample liquidity to the banking sector, as its balance sheet soared with banks taking advantage of access to funds on favourable terms.
Markets are now assuming the peak in policy rates is close, which seems right, but are probably premature in factoring in rate cuts later this year. However, a departing member of the BOE’s Monetary Policy Committee this week suggested that policy rates could fall this year.
That leads onto the second area, which has been the focal point for markets in recent weeks: the banking crisis. This has proved to be specific, not systemic. That is, the problems were apparent at specific institutions, not system wide. In the US, one aspect was the need to protect depositors. The UK banking sector proved resilient.
While markets became relieved that this wasn’t to be the start of a new financial crisis, concerns naturally remain about whether other, wider problems will emerge at some future date if monetary policy tightens further, or economies slow.
Inflation is still persistent
A third area, and at times the dominant theme, has been inflation. Headline rates of inflation are falling across most countries, yet troubling higher prices are far from conquered. In the UK and other European countries, the pace of deceleration is heavily impacted by energy policy, including whether governments provided subsidies or set some prices during the recent energy crisis. Food price inflation remains high, too.
Markets believe that headline inflation rates may undershoot targets looking one year ahead, before then rising again. The concern, though, for markets and policy makers is where core inflation – which excludes food and energy – may settle. This, too, may prompt central banks to retain their bias to tighten until they are clear that core inflation is tamed and in turn may rule out rate cuts.
An uncertain growth outlook
The fourth area is growth. Compared to the start of the year, the UK economy has proved stronger than expected. A recession has been avoided. Corporate balance sheets appear in good shape. Surveys also suggest many firms are more optimistic about their own situation than the broader economic outlook. At the same time, though, there are signs that the labour market may be softening.
Monetary policy tightening from over the last year is feeding through, and to this there is now the need to be mindful that the banking crisis could lead to a tightening of credit conditions, even in countries like the UK that were not directly impacted by that crisis. There is thus still much uncertainty about the growth outlook. We expect the UK to avoid recession and see modest growth this year, with decelerating inflation allowing a rebound in spending later in 2023.
Another important focus for markets early in the year was China’s post-pandemic opening. This transformed expectations about global growth. The potential for China’s economic outlook this year was also revised sharply higher, helped, too, by China proving to be one of the few countries where the central bank was able to ease policy.
For emerging economies, though, it has been a mixed quarter. Last year, emerging economies faced headwinds, and many of these are now tailwinds, although perhaps not as strong as we had hoped, so the picture is mixed.
Last year’s headwinds included a stronger dollar, higher US rates, weak Chinese growth because of lockdown and sluggish world trade. The latter two have changed, and a stronger dollar is less of an issue. But higher US rates have now been followed by the recent banking crisis in the west leading to fears that many smaller emerging economies may find it harder to access capital markets on favourable terms.
Geopolitics, given the war in Ukraine, has never been far from the attention of markets. This has impacted energy markets. The second quarter has begun with a renewed focus on geopolitics and also on oil, given Saudi Arabia’s decision to curb output.
Many of these themes are likely to remain centre-stage in the quarter ahead, and we will follow up here in coming weeks with a focus on the prospects for specific countries, beginning with the UK.
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