By Ven Ram, cross-asset strategist for Bloomberg Markets Live
Policy rates in the U.K., U.S., Canada and the euro zone trail forecasts bootstrapped from the Taylor Rule by the most, suggesting that terminal rates in the most advanced economies may be underestimating the task ahead for policy makers.
Policy rates in those economies lag the implied policy rate by 3 percentage points or more, while the gap is narrower in New Zealand and other nations where central banks are trying to kindle inflation.
Traders are pricing terminal rates from about 0.30% to 2% from across the euro zone to Canada. That illustrates skepticism on whether central banks will be able to push through the rate hikes they are penciling in and whether their economies will be able to withstand such moves.
For instance, the median dot plot for the Fed funds rate at the end of 2024 is 2.125%, while the terminal rate priced by the markets is around 1.83%. Just in the past week we have seen traders positioning themselves for a steeper rate trajectory, with some bracing for a 50-basis point increase as soon as March.
With Fed Chair Jerome Powell suggesting that a balance-sheet runoff will commence sooner in this cycle than the previous time, and Governor Christopher Waller saying the exercise “will take some pressure of longer-end rates,” it may be that the historical response of a flatter curve concurrent with a hiking cycle may have to be rewritten.
The Fed is “way behind” the curve, and the policy rate should be anywhere from 3% to 6%, not the near-0% now targeted, John Taylor, who coined the eponymous rule, remarked at the annual meeting of the American Economic Association.
In the U.K., the terminal rate is around 1.10%, which may reflect comments by Bank of England Governor Andrew Bailey that interest rates are unlikely to climb back to pre-financial-crisis levels.
Still, with inflation in the U.K. north of 7% and 5y5y inflation swaps around 4%, it’s inconceivable that raising the Bank Rate to 1%-1.25% will put the inflation genie back in the bottle.
In Canada, conviction that the central bank won’t raise rates before April is being tested. A Bank of Canada survey of business executives described an economy running increasingly hot, with labor shortages, record inflation expectations and strong demand. Markets are pricing in as much as 200 basis points of tightening over the next two years. That would go a long way toward bridging the gap implied by the Taylor Rule.
The euro zone may be the exception. Even if the Fed raises rates more than three times this year and the BOE follows suit, it’s inconceivable that the European Central Bank will be keen to raise rates for fear of committing a policy mistake. While the ECB may reduce the pace of its enlarged asset-purchase program from the second quarter, it may still be hesitant to raise rates before the first quarter of 2023. Even in such a scenario, it will move in measured steps, meaning its deposit rate will take a long time to even reach zero.
The Taylor Rule, which was coined in the early nineties, served as a guide for developed-market central banks until the onset of the global financial crisis. However, the Fed unveiled quantitative easing in response to the crisis, and it’s become part of the global central banking tool kit, deployed at the first sign of trouble. That meant that policy rates began to diverge drastically from the path implied by the rule.
The lack of an adjustment factor for the impact of QE marks a crucial limitation of the analysis, which means that perhaps not all of the gaps between terminal rates and the Taylor rule may be bridged in the current policy cycle.
