As inflation continues to run at multi-decade highs, especially in developed markets, major central banks have stepped up the pace of removing policy accommodation. One exception is China, where the central bank has adopted an easing stance to fight weakening growth.
Hawks in the West
Last week, the Bank of Canada (BoC) and the Reserve Bank of New Zealand both raised their policy rates by 50bp. The BoC also announced the end of reinvestments under its bond-buying programme, marking the start of quantitative tightening. The 50bp rate rises were the biggest for both central banks in more than two decades as policymakers intensified their fight against soaring inflation.
The market also anticipates that the Bank of England (BoE) to raise rates again in May. The US Federal Reserve (Fed) is expected to announce a 50bp interest rate increase at its next policy meeting.
These actions will likely increase the pressure on the European Central Bank (ECB) to publish a firm interest-rate action plan. This has been missing so far.
Behind these hawkish stances is soaring inflation. In the UK, consumer price inflation hit 7% year-on-year (YoY) in March on the back of rising food and energy prices. Some market players foresee it increasing to 9% soon due to a planned 54% rise in regulated energy prices this month. Core inflation rose at a robust 5.7% YoY, also owing to rising services inflation.
While the BoE is expected to retain a tightening policy bias, it is caught between two conflicting concerns: High inflation (which requires monetary tightening) and threats to economic growth from reduced purchasing power (which require policy easing).
There are also signs for continued vigorous inflation in Europe, with German CPI inflation soaring to 7.6% YoY in March (February inflation in the eurozone was 5.9% YoY).
The price pressures have led to heated debate at the ECB with last week’s policy meeting ending with a hawkish tone. In particular, the ECB noted that incoming data had ‘reinforced’ its expectation that net bond purchases under its asset purchase programme (APP) should end in the third quarter.
However, it did not signal a clear acceleration in the pace of policy normalisation or specify the exact timing for ending APP purchases. If the ECB does not clarify its policy soon, policy tightening elsewhere will start to put downward pressure on the euro, adding to inflationary pressures on the eurozone and forcing the ECB to eventually take action that is more drastic.
US inflation has risen faster than at any point since the early 1980s (see Exhibit 1). The headline CPI and PPI rates for March surged by 8.5% YoY and 11% YoY, respectively.
To date, the Fed’s policy reaction function has been univariate – focused on just one variable, inflation. This means that the near-term path for rate rises depends almost entirely on the trajectory of inflation. The market expects the sharp rise in inflation to keep the Fed on track to raise rates by 50bp in May and start shrinking its USD 9 trillion balance sheet after the May meeting.
The dove in the East fighting growth weakness
One significant concern hanging over financial markets is a worsening of inflation shocks in developed markets fusing with a sharp slowdown in China’s growth to disrupt the global economic recovery. Data on first-quarter growth in China has underscored this worry. GDP grew by 4.8% YoY, mainly on the back of a strong performance in January and February ahead of Covid-related shutdowns. On a quarter-on-quarter basis, however, growth slowed from the end of 2021.
The number of new Covid cases has remained at over 25 000 a day, the highest since the pandemic started in 2020 (see Exhibit 2). As Omicron hit, economic activity in March and April decelerated sharply.
The risk of faltering growth momentum threatening the government’s 5.5% growth target this year is rising. The Covid-related drag appears to be building as lockdowns in high-risk areas, notably Jilin province and Shanghai, were extended over the past week. The slowdown can already be seen in the sharp fall in the purchasing managers’ indices for March and weak import growth. China’s weak growth aggravates existing supply-chain bottlenecks, dragging on growth in other regions and boosting inflation.
Last week, the People’s Bank of China cut the required reserve requirement ratio (RRR) by 25bp – less than markets had expected. The cut took the average RRR for financial institutions to 8.1% from 8.4% and effectively released RMB 530 billion in liquidity. Before the RRR cut, the central bank had also cut mortgage interest rates by an average of 40bp to alleviate the pressures on the property market.
However, with the Fed poised to raise rates faster and the US 10-year Treasury yield already above the 10-year Chinese government bond yield, the PBoC’s room to manoeuvre is constrained.
Further action will likely come in the form of quantitative easing, such as more RRR cuts, the relaxation of prudential regulations, and the buying of foreign exchange to curb the strength of the renminbi and inject liquidity into the system.