Fed, ECB and UK Budget: A Big Week for the Global Economy

Hello, it's Friday the 23rd of October and this is your capital economics weekly briefing. I'm Paul Dales, chief UK economist, filling in for Neil Shearing while he visits clients in Europe. Next week is shaping up to be a very big one for the global economy. We have interest rate decisions from both the Fed and the UCB, not to mention one of the biggest dates in the UK economic calendar, the budget. And there's plenty at stake. Central banks are still wrestling with inflation risks. Markets trying to work out how far rates might rise and the UK Chancellor faces a difficult balancing act of providing support with the cost of living without alarming already nervous bond markets. I'm joined today by our chief global economist, Jennifer McEwen, together we're going to cut through the noise and ask what really matters next week and what could genuinely change the outlook. Hello, Jenny. Hi, Paul. Let's start with a Fed, what are we expecting next week? We expect the Fed to leave rates unchanged at 3.75 to 4%, but the important point is that this is a pause, not the end of the tightening cycle and I think it will signal as much. We expect another 25 basis point hike in December and another in March, which would take rates to four and a quarter to four and a half percent. So I think really the key message is on hold next week, but not done. So why the pause when the inflation news has been pretty uncomfortable? Yes, you're right. It has been quite bad news on the inflation front, but at the same time, the Fed has signaled quite clearly to markets that it wants to tighten at a relatively measured pace. It raised rates in September, so very recently and Fed President John Williams for example was subsequently stressed that there was no need for urgency and that the Fed has time to gather more information. So it's said that it's still pretty quickly and I think at this point, a big surprise for markets in the form of a rate hike could have quite an adverse reaction. It could lead markets to believe that the Fed feels it's fallen behind the curves and that there's going to be an aggressive tightening cycle. So you might get a really sharp tightening in financial conditions if it were to surprise markets now. That's all very well and good. But I mean, how serious is this inflation problem that the Fed needs to deal with? It does look fairly serious. Actually, September's CPI and PPI data were too strong for comfort. We estimate the core PC rose by 0.35 per month or month, which would be a far faster rate than would be consistent with the Fed's target. And I think maybe the biggest issue from the Fed's perspective is that September's price data revealed really broad-based strength. This isn't just an energy issue and your core services, excluding housing inflation, ticked up to 3.1%, so significantly higher than the target. And I suspect that that will be the most concerning factor for the Fed. At the same time, forward-looking indicators have deteriorated too. We look at various business surveys of price pressures. Price is paid, indices, price is charged, indices, including those from the ISM business surveys. And they've hit a four-year higher recently. So they're the highest. They were there as high as they were back in 2022 when we know that inflation pressures were really quite intense. Long-term inflation expectations have risen as well in the US. So that's something that would really concern a central bank. So energy is part of the problem here, but it increasingly looks like more than just another oil shock. And as well as what the Fed does being important, it's always the case what the Fed says being important as well. And we're all still trying to get to grips with the relatively new Fed chair Kevin Walsh's communications. But what do you think we should listen for from him this time? Yes, that's right. And he has his work cut out for him after confusing markets a bit early in his tenure. He needs to try and be as clear as possible. I think there are big questions around the likely persistence of inflation and how the Fed feels importantly about the likely persistence of inflation. We'll be looking for any comments that give us a sense of how it's considering the balance between the labour market and financial conditions and the inflation data. It's quite likely that he will express concern about the broadness of price pressures. Perhaps relative optimism about the labour market, although we had that soft non-farm payrolls print in September, he will probably state that labour-cut market conditions are still relatively positive. Also, one point he's been making recently is that financial conditions despite the tightening, despite the hiking of interest rates that we've seen already, that financial conditions are still pretty loose. So if he continues to make that point without expressing any real concern about the wobbles that we've seen in the equity market recently, then that again will speak towards a relatively hawkish message. It's possible also that he could reiterate the view of some FOMC members that the equilibrium interest rate has risen somewhat, which would suggest that whether Fed expects to end up, where it expects interest rates to settle, it is a bit higher than might otherwise have been the case. So all of those points, all of those kinds of communications, would point to a further tight need to come, so that would leave us with a relatively hawkish old and might support our view that U.S. rates are ultimately likely to stay higher for longer than interest rates in Europe, for example. Yeah, that's a really crucial point. And regarding that, the European Central Bank also meets next week. Are you expecting the UCB to come out with a similar outcome? Yes, that's right, we expect the UCB to leave its deposit rate unchanged to a two and a half percent. And as with the Fed, we think there's another hike probably coming in December, so clearly some similarity there, but I think that probably is where the similarities end. I would expect Christine Lagarde to sound much more balanced in her communications than Kevin Walsh indicating perhaps that this is fundamentally a supply shock, which as well as boosting prices could dampen economic activities. So much more balance there. She is also likely to stress again as the ECB has repeatedly in its recent communications that there's no sign of so-called second round effects at all, so that although energy inflation is boosting headline inflation, we're not seeing that pass through to broader price pressures and to wages, which would really concern Central Bank, so that's another difference relative to the US where price pressures are broader. So we expect December to be the final hike of the cycle for the ECB, actually, it might hint that that hike is coming in December, but we think that's probably as far as things go, given the relative fragility of the economy and the absence of underlying price pressures. And that views really very different to that of financial markets, which expect interest rates to go up to around 3% and stay there. So I mean, inflation is rising in both the US and the Eurozone, and that's pretty clear. So can you explain in a bit more detail then why we're more relaxed about the outlook for inflation in the Eurozone? I think the point is that if we look at the Eurozone data, it is pretty clear that this is overwhelmingly an energy shock. Gas and oil prices are much higher than the ECB had assumed that they would be when it last produced forecast back in June, but there's no real evidence that core inflation is responding to that, even food inflation, which you would expect to be impacted indirectly by higher transport costs, higher fertiliser costs, it's still coming down if anything. So there's really very little evidence of any pass through from this energy shock to broader price pressures, and that's quite different to the situation in the US where it may not be direct pass through from energy prices. But it is clear that broader price pressures are rising, that there is a general increase in inflation, in core inflation, across the US, which just isn't materialising in the Eurozone. And in terms of how things could change then, what could change the view on the Eurozone, what could make us more worried about the inflation outlook over a longer period? As you know, our view is that energy prices will start to come off next year. That's our assumption that the oil and gas prices start to fall. If that doesn't happen, if energy prices stay much higher for longer, or indeed if there's a renewed surge in energy prices, then the risks have passed through to the broader economy become much more significant at that point. And it's really these second round effects on wages and on wider prices that we're looking out for. So if energy prices fall back as we expect, then we won't feel too concerned, even if they remain where they are, and firms continue to find workarounds for that wage growth remains relatively soft, then we would think that the ECB wouldn't need to hike rates too much further. It's really if we start to see, if we see a bigger rise in energy prices, or if we see meaningful passes through in terms of consumer prices and wages that will feel more concerned. So I find it quite interesting that we're talking about what central banks might do next when central bankers themselves seem increasingly reluctant to essentially tell us what they're intending to do. I mean, is it the case that forward guidance is now dead? Actually, no. And a lot of people have talked about that, actually, and of course Kevin Walsh, she's pushed back quite hard against the idea that central banks should provide forward guidance. But really the central argument of my latest. global economics update is that it's not dead at all, it's just changing form. The sort of traditional explicit forward guidance, particularly the type that we saw following the global financial crisis when interest rates were at around the zero bound has gone out of favor, but it's just much less appropriate that type of forward guidance than it was previously. When interest rates are close to zero, it's quite important for central banks if they want to continue offering support to the economy to signal that rates will stay low for a certain period so that they can bring longer term interest rates down and manipulate the market in that way. And that's when it's important for them to give calendar-based guidance where they say interest rates will stay at this low-rate until say 2013. What's more important now and what's taken the place of that calendar-based guidance is a state contingent guidance. If this happens, then we will do this with interest rates. And that's really well suited to the enormous uncertainty that we're seeing now. Christine Lagarde, for example, has repeatedly stressed that the ECB won't pre-commit and that it's data-dependent, and that makes sense, but there is still a form of forward guidance there. Yes, the ECB is not pre-committing come what may, but it is saying if the data do this, then we will do that. So we think that if we have a continued absence of core price pressures, if wage growth remains well-contained, then the ECB will hint that it's unlikely to raise rates much further in that scenario. And just going into that a bit deeper then, what is the implicit guidance telling us now in your view? Yeah, well, the ECB, for the ECB, it's telling us that energy prices and the direct impacts of energy prices are crucial. That really is what it's laser focused on, and whether the rise in energy prices that we know about, that the part that we know is starting to generate broader impacts on on prices. So that's where the uncertainty lies. It's pretty clean. So far as the ECB is concerned, what is the rise in energy prices doing to the rest of the economy? And that's what it's focused on, and that's what it would look for. So far as the ECB is concerned, as long as those second round effects don't start to materialise, then we can assume the interest rates don't rise much further. For the said though, I think its forward guidance is telling us that it's focused on much broader price pressures, because it's in a different situation, because those price pressures have been materialising to a greater extent. So for that reason, I think what it's telling us is that it's going to focus on a broader set of indicators that would include commodity prices, but also things like financial conditions and the strengths of AI investment, which has been a key driver of economic strength and of potential inflationary pressure in the US. For Japan, the Bank of Japan actually meets as well next week. For Japan, it's different again. It's likely to reiterate that its focus is much more on domestic inflationary pressure. It's in a different situation to the said, very different position to the ECB, where it's really clear that the labour market in Japan is tight that wage growth is rising, and interest rates are starting from a relatively low point. So there's some policy normalisation that needs to come, and I think the Bank of Japan is likely to signal that it's almost on autopilot. So far as that's concerned, yes, the energy shock is a potential additional inflationary pressure, but it's the fundamental domestic price pressure that it's more concerned about, and it's likely to signal that interest rates are going to rise further, insteadly. The Bank of England is on a slightly different schedule this time, it doesn't meet until a week after the other central banks. My view is that it really sits in that first group with the ECB, where it's the energy shock that is the biggest concern and the fundamental concern, but you're the expert here, actually, Paul, so how do you think the bank compares to others, and what do you think we're here from in November? I think your spot on, it's much more like the ECB than the bed in that the Bank of England is facing, an energy shock that's coming in from overseas, rather than domestic inflationary pressure has been very strong. So its response really does depend on the risk of that energy shock spilling over into the second round effects that do trigger strong domestic inflation. And up until recently, the Bank has been reasonably willing just to sort of place its bet that there won't be second round effects and keep rates on hold, but with energy prices just haven't stayed so high for so long now after the Iran War started. There's now of the view that they need to do at least one, maybe two, insurance interest rate hikes just in case there are second round inflationary effects coming further down the line. So we think the bank will hike interest rates by 25 basis points at the next meeting in early November, taking them from 3.75 to 4% and then we've also pensed in one more hike thereafter. But in a similar case, the eurozone, we don't think these second round effects will emerge, so we don't think interest rates need to rise as far as the markets are expecting. And also we suspect that that interest rates might be able to be reduced again quicker than people expect. So you might get some cuts in very late, 2027 and going into 2028. Before that though, you have the UK budget, which you'll be focused on over the course of next week. What are you expecting? Yes, that's right. On Wednesday 28th of October, the Chancellor John Healy will deliver his first budget. We think this will be what we call in a compromised budget, really, one that does a few things here and there, but doesn't attempt to resolve all the UK's fiscal issues at once. In simple terms, that means there'll probably be a bit more borrowing. There'll be a bit more taxes and perhaps a rise in spending much smaller than he and his Prime Minister would ideally like. In terms of numbers, we're talking about roughly 10 billion pounds of additional public spending by the year 2029-30 funded by around 5 billion pounds of net tax rises and something like 5 billion pounds of extra borrowing. And when it comes to those tax rises, they're probably going to be tilted towards high-income households and banks while the spending package may include some temporary cost of living support for low-income households and perhaps a bit more capital investment as well. Okay, so that doesn't sound like a massive amount. Do you think it will offer any support really to the UK economy? Not very much. So we estimate that the temporary cost of living measures could boost demand by about 0.1% in 2026-27. And maybe there'll be a similar boost a few years ahead from higher capital investment, but the bigger issue really is that the UK is embarking on a pretty tough tightening in fiscal policy and we think that most of that will stay in the projections. So this budget won't really make much of a difference to the economic outlook. Instead, it's more about just maintaining the UK's fiscal discipline at a time when the bond markets are around the world are a bit nervy. Yes, okay. So speaking of bond market, how do you think financial markets are likely to respond to all this? Well, if we're right that it's going to be a relatively small budget and if things come in line with our expectations, when I don't think there's going to be much reaction at all in guilt markets, I think the real big driver of guilt markets at the moment really is the outlook for inflation and interest rates that we've already talked about. So in that sense, what the government really is trying to achieve in this budget is just to keep things really steady and not rock the guilt market and I think it will probably achieve that. Okay, right, so good news. Does this mean that the budget resolves the UK's fiscal problems then? Can we stop worrying about the UK and take it out of that bucket that it's falling into with France and it'll be as sort of the high debt economies where a fiscal crisis is a risk? Should we still be worried and what's going to come next? Well, I think that's really interesting because we know the problems going on in France at the moment are really crystallising and it is worth saying that the UK is not France, its fiscal position isn't as bad and its fiscal trajectory is much better. But the budget will leave a lot of unresolved decisions that need to be made at some point. The UK has got a lot of spending pressures that it needs to take account of. The Prime Minister has a lot of policy ambitions he needs to fund. They're not going to be solved in this budget and that just leaves a lot of tough decisions to be tackled next year, probably in a spending review and a budget which may come at the same time this time next year. So it is really a bit of a case of kicking the can down the road. There is tougher decisions to come, but at the moment at least the UK is not looking like the most fragile fiscal economy that's certainly France at the moment. Okay, thanks, Paul. I know you'll be participating in one of our online drop-in sessions next week to talk through your views on the budget once we've heard. Yeah, absolutely. I believe you are too. So that will be 3pm UK time on Wednesday. So typically the Chancellor will finish his speech maybe around 1.30. Shortly after that you'll be able to hear what we think it all means and most importantly will be on hand to answer your questions in that 20 minute online. session. Excellent, I'll look forward to it. So a huge week ahead, the Fed, the ECB and the UK budget with very little room for error, we'll be watching all three events very closely. 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