Stephanie Kelly 0:06
Hi and welcome to macro bites, the economics politics and policy podcast from abrdn, I'm your host, Stephanie Kelly. And this week, it's part two of our series looking at the impact of Omicron and other global shocks on the economic and policy environment for investors. So last week, we talked about Omicron, supply chains, China. This week we're going to be exploring how major developed central banks are likely to behave this year as they grapple with these really significant reopening pressures, shifting labour markets, and the broader inflation picture. So to help me explore all of this, I'm delighted to be joined by my co-host and monetary policy expert Luke Bartholomew. Hey, Luke.
Luke Bartholomew 0:44
Hey, Steph, how's it going?
Stephanie Kelly 0:44
Thank you very much for joining and Deputy Chief Economist and US expert, James McCann. Hey, James,
James 0:50
Hey, thank you for having me.
Stephanie Kelly 0:51
Great to have you. So let's jump right into it. And we're gonna have to start with those jobs numbers in the US. Last week, we had some, I would say pretty surprising numbers come out of the US labour market last Friday. James, could you talk through why was it such a surprise to investors? And probably to central bankers?
James 1:12
Yeah, absolutely. I'd say the surprise probably came through through two channels. One was just the sheer strength of jobs growth in January, we know that the US has been going through an Omicron wave, we know that has, by an order of magnitude smashed the number of COVID cases, unfortunately, that people have been going through. And I think the expectation in consensus in broader central banking communities was that this would weigh on activity will be in perhaps over a relatively short period of time, but that we should expect a disrupted labour market report. And what we got was nearly half a million jobs much, much stronger in the short term that is unexpected. And then the other aspect of the report, I think, was interesting, but also threw a lot of noise into into things was that there were huge revisions. So we had awkward revisions that last two months data of around 700,000 jobs and big revisions to the to the labour force estimates as well. So really, it creates this sense that there's a lot of noise in the payrolls numbers, but also that the near term picture is looking quite a lot stronger than people would have expected, absent the Omicron wave.
Stephanie Kelly 2:18
So I think that's I mean, the obvious question is like, why has this happened? How can this happen to see these kinds of revisions?
James 2:26
I mean, there's probably two factors. Again, I keep moving on to two things. I'd probably say the first is that this is part of the benchmark revision. So it's normal that at this time of the year, the BLS take into account, other data sources, which tell them something about the state of the labour market, the size of the civilian population, they breed, they're able to incorporate other data sources, and they do so at this time of the year, take them off colour picture of the labour market, so that that's a normal process. And so we normally get some revisions and change the picture of the labour market a little bit in early in January. The other issue that you've got there probably, too, is that the pandemic just did extraordinary things to the labour market in terms of job losses, at certain times of the year, you wouldn't expect to see job losses, interruptions across sectors that look quite different in the service sector or other sectors, which had fewer pandemic restrictions as well. And that's really affected the seasonal adjustments. And that's what the BLS suggested this time of year is year two. So when it seasonally adjust its data, when it's found through the pandemic is there's been a huge amount of noise. And a good example is around school closures and what that's done to two employments in the education sector that's really wreaked havoc with the seasonals. And they've tried to, to amend that a little bit to better capture what's happening in terms of real time, labour market hiring and firing decisions.
Stephanie Kelly 3:50
So I guess the natural question then is do these revisions not only obviously, the upside surprise, but the prior visions? Did they change any of your priors around how you're thinking about the outlook for the US economy? And how do you think that this will factor into the way that I know we're gonna go into the specifics of Fed policy and other central banks, but do you think that this change is meaningful for them as well?
James 4:12
Yeah I think yes, I'll probably probably both counts. We're not not enormously but I think the message that I probably take and I think watches at the Fed will take will be that this is still a labour market, that is, you know, very, very robust shape. So if we look between the details, there are signs of the Omicron crisis there. We certainly say that I was working in some sectors have dropped, and that probably reflects the degree of absenteeism as people have been unwell, we've seen one or two finds within within the details of report about people not being able to work or their employer closing for periods of time during during January. So there are some signs there. But, you know, that really sort of says to me, how strong would if this report being absent the Omicron wave, and as we see cases received, you know, certainly at least To be relatively confident that the strength of the labour market will persist. And the final point might be that when we look at the spread of the virus and the impact it's had, you know, certainly this makes me maybe a little more confident that the economy is becoming increasingly resistant to outbreaks. If we go back, obviously, the first wave of cases in 2020 was hugely disruptive. And we've had subsequent waves, each one of those has had a lower impact and as you know, good public health responses and epidemiology reasons to try and explain that. But I think the Fed will be looking at it and think he gets judgement that this will enduce some short term volatility, but not really, too serious damage to the economy probably feels about right.
Stephanie Kelly 5:43
Yeah. So hopefully, hopefully, you know, signs of green shoots, and particularly for those of us who I think are most people are hoping that, that this pandemic kind of takes, you know, the next step becomes a little bit more normalisation. Again, I mean, Luke, can I bring you in here in terms of maybe if you think about the outlook for central banks? I mean, how much are labour markets in Europe beyond the United States, acting as an important constraint or incentive for central banks, say, in Europe in the UK?
Luke Bartholomew 6:10
I think the key to that thinking and I mean, there are quite important cross country differences that relate to different viral experiences, different public health responses, different macro policy responses, different labour market institutions, it's mean, that, you know, there are slightly different cross country differences in what we're seeing. But the broad picture is that both for the Eurozone as a whole and the UK, that the dynamics are quite similar to the ones that James described for the US, that we are seeing very robust demand for labour, at the same time that there seems to have been this negative shock to labour supply, which means that labour markets are extremely tight at the moment. And generally that's that's a good thing. I mean, probably the problem that we've had for much of the post crisis period is that we've had probably persistently weak labour markets, and we could have could have run the economy harder, and could have had tight labour markets. But what you get with tight labour markets is stronger wage growth. And we might be getting to a point that in some countries getting a level of wage growth that's simply not consistent with meeting inflation mandates over time. And I think that is what's going to bring central banks into play big time.
Stephanie Kelly 7:22
Right? Right. Absolutely. And it did feel like for a very long time, we were looking for these things to happen. And then I classic for markets, once it actually starts to happen, it becomes a source of concern for further reason. So beyond labour markets, what are the other things that you think policymakers but again, outside the US are going to be looking to at the moment for key signals, and obviously, there's huge political and voter interests in the question of energy markets and energy prices, but are those the kind of things that are going to weigh on on an ECB or, or BOE policymakers thinking about the path forward.
Luke Bartholomew 7:56
So traditionally, energy price shocks are sort of paradigmatically, those kind of shocks that central banks can, quote, unquote, look through, which is to say they take it as a temporary shock away from their inflation target, but they don't set policy to respond to that. And that's partly because A, you know, you would expect these kinds of shocks to be one off sort of level price shocks. And you know, in time, it's just as likely that an upward commodity price shock could be met with a downward one. And these things sort of drop out and take care of themselves. And the other, of course, is that monetary policy acts with very long lags. And if you start tightening policy today, for energy price shock you see today, well, that's not really going to start affecting the economy per se 18 months down the road, by which point you'd expect that energy shock to have long since dropped out the inflation data. So you're sort of like by setting policy for that shop today only affecting a future world war isn't really a problem. Now, there are sort of like nuances around that in terms of like, how you sort of think out those trade offs, how quickly you want to bring the shock back to target and if it's so extremely large, or maybe you have to start thinking about a policy response. But I think the most important caveat is that this sort of look through it response is all conditioned on the idea that inflation expectations are well anchored, and that in time high inflation will fall back to target precisely because those expectations are in the right place, and the shock doesn't drag them higher. So the key question right now, and the reason why these energy price shocks might be a little bit more important than sort of that paradigmatic textbook case is just because inflation expectations seem to be drifting higher at the same time. So maybe because of this labour market tightness, the energy price shock does sort of count for a bit more because of what it might do to expectations.
Stephanie Kelly 9:50
That's exactly what I was going to ask you, right? Where are inflation expectations at the moment as you see them, I mean, obviously, you kind of mentioned there, there's some upward pressure is there you know, is there threshold at which you'd be more concerned or? Or do you think that this is just a you, I guess, do you think it's appropriate the level of inflation concern and where inflation expectations are today.
Luke Bartholomew 10:10
So short term inflation expectations have moved a lot higher recently. But those kinds of things tend to sort of lag rather than lead inflation, they sort of just follow where inflation has been, and in particular, where energy prices have been. So in some sense, it's not really surprising that those have been dragged higher, I think, much more interesting and potentially concerning the central banks is what's happening to medium and long term inflation expectations, we tend to put much more weight on those as actually having forward looking content. Those are the kinds of things that get built into wage and price setting arrangements. And there is evidence that those have moved somewhat higher. Now granted, in the Eurozone, we were sort of starting from a place where if anything, inflation expectations, were too low. The problem that the ECB had battled for a very long time was, was, frankly, that expectation become unanchored on the downside, so some upward pressure, there isn't necessarily a bad thing. But speaking for the UK, for example, I think, I think it is pretty clear now that most measures of inflation expectations and again, like these aren't a clean thing to measure, you have to sort of pull in surveys from various different sources, market prices. But generally, there is a sense that sort of the kind of numbers that you would think, or at least traditionally have been consistent with inflation at a target, what we're looking at now is numbers a bit higher than that. And that has sort of what, what has sort of triggered some of the concern from the Bank of England, and they're worried that this is going to, you know, not wage price spiral levels, but at the very least start to be embedded and get that much harder to squeeze out. Right.
Stephanie Kelly 11:51
Okay. Well, I think that's a really useful place to start and to think about what central banks are actually likely to do. And in particular, you know, we didn't actually talk obviously, last time, we've talked a lot about China, and we're trying to fit in. So one last question to you before we get onto central bank, and prognosticating predictions .dangerous world, is how supply chain issues in China are likely to, if at all affect the way central bankers in the West think about the pressures that they face.
Luke Bartholomew 12:20
So I think, again, traditionally, those sort of supply chain shocks would fall into the same bucket as the shocks, I talked about the kind of things that you'd look through, you think of as temporary, there's not really reason to think they continue to put upward pressure on prices over horizon where monetary policy changes today have would have any effect. And moreover, a fair bit of it could just be relative price changes rather than sort of fundamental changes to the inflationary process. So in theory, the kind of thing that they should be able to look through. But again, the key question is, as long as expectations stay anchored, and the consignee be that it's just another bit of that perfect storm, and you've got the underlying wage pressure building, you've now got the energy price shocks, you've got the sort of the supply chain shocks that looked like they were being fixed. But now maybe that's exacerbated and takes a little bit longer because of Omicron. So it's just another reason to worry about what might happen to inflation expectations, rather than necessarily something that central banks can deal with directly. I mean, it isn't like Central banks can print more, you know, semiconductors or reduce shipping times themselves, right, they might be able to keep inflation expectations anchored over the medium term, as long as they credibly demonstrate commitment to their targets.
Stephanie Kelly 13:35
Sure, that means I mean, that makes a lot of sense. So let's bring it all together. And James, coming back to you on the Fed. What can the Fed do in this context to affect the inflation outlook?
James 13:46
Yeah, absolutely. I think you're following on from from Luke's comments. So they can affect this through a few channels one, and admittedly, it's one that comes with a lag because they can, they can try and influence the demand side of the economy. We know that they can't affect foreclosures, or the physical supply constraints that are pushing up a range of good prices at home and abroad via through the energy channel or through those good shortages. But if they think part of the problem is that there's a an issue in an excess of of demand over supply the need, they can dump and that's what that demand side and you can do that through starting a policy adjustment, and then totally agree, the second is that they can start calming expectations or preventing expectations coming on anchored. And by doing so by showing it I liked in a credible way around around them. So you should target and in some ways they've they've already started this process, even though they haven't actually really tightened policy. As yet. We've seen a very significant shift in the Feds forward guidance. If we just think back to this time next last year, the Fed was saying that it wouldn't tighten reach out to the end of 2023 that the Fed meeting just recently in January, I think Powell was pretty open that the Fed wants to tighten it In March, so that's a really significant migration. And you see that already is what's embedded around fed expectations in market interest rates to two year, even since September is more than 100 basis points 10 Year, not quite that much, but fairly significantly, too. So the Fed already through its guidance is telling us the policy is going to be tighter than the market is already reacting in a way, you know, and that change in the interest rate shock should be one that feeds into overall monetary financial conditions and affects growth inflation, albeit as Luke mentioned with with lags, but also provides a degree of credibility around how the Fed sees its inflation target.
Stephanie Kelly 15:38
Sure. And so, in that context, obviously, as you said, they've set the scene. What are you expecting by way of rate hikes in the coming year?
James 15:46
Absolutely. So the Fed told us back in December, they thought, according to the medium dots for the medium member on the FOMC, it'd be right to raise rates by three, three times this this year. I think that messages coming out of the January meeting, although they did not date, those thoughts were more hawkish and probably illustrative of the Fed that shifted in a more aggressive direction. At the moment, we currently saying they'll hike rates four times, that's roughly once every every other meeting, I have to say my, my sense is that actually the risk of very clearly drifting towards them having to do to do more and hiking at nearly almost every every meeting. So it could be that they high five or six times this year, just given the fact that that short term inflation dynamic does seem to be very pronounced, there are risks to that from from the COVID shot, and the labour market seems to continue to be very strong. So the chance that they front load a little bit more and do more sooner than the fourth and the four interest rate hikes that we've currently got pencilled in, I think the interesting point will be as well, not just how quickly they go into where they start betting the market has a relatively benign view of the Fed stopping relatively low terminal rates. So and rate for the Fed Funds peaking somewhere between one and a half and 2%. There's a real risk that if inflation doesn't slow this year, then the Fed feels it needs to significantly overshoot that because it again, has to clamp down both on the demand side, but also to keep inflation expectations in check.
Stephanie Kelly 17:13
Right. Right. I think that's that's a super, super useful summary of the rates outlook. And then what else do they have in the armoury? Can you explain a bit where the whole QE and balance sheet runoff come in, and this?
James 17:23
Absolutely did, the Fed, I think is of a mind to reduce the size of its balance sheet. We know that through quantitative easing, it buys assets, public sector assets, government bonds, and private sector assets, mortgage backed securities, and it holds them and it knows that these influence interest rates on a longer term horizon should be buyers across the yield curve. And it knows that that's a tool that can use a long time, a long time alongside its short term interest rate, to influence broader financial conditions and interest rates and longer durations. Now it's out with a balance sheet of nearly $9 trillion, obviously, extraordinarily large, it signalled that they would like to reduce the size of the balance sheet, and it would like to do so earlier soon admitted. So in the 2010s, after it's as it started its previous tightening cycle. So I think that's a clear sign that the Fed may be moved a little bit more aggressively in unwinding that quantitative easing. But I think very much the Fed is going to want to still have that process on on autopilot. I think it's, it's fairly open, that it has a weaker understanding of how rundown affects broader financial conditions, I think it's relatively opaque for households, for markets to about what different speeds and degrees of tightening from the balance sheet side due to activity and inflation of different horizons. So I think very much it's going to want to use it short term interest rates as its key signal around where the direction of policy is going. But definitely, we should have, we should expect the Fed to start I think relatively soon, probably in the second half of the year, winding down that enormous balance sheet, doing so in a steady and predictable manner, but doing so in a way that will, in itself contribute to a broader tightening in monetary and financial conditions. So that'll be a little tightening, that it's doing sort of just in a consistent and predictable manner, which goes alongside its increases in interest rates.
Stephanie Kelly 19:16
Great, consistent and predictable is definitely what markets would prefer from their central bankers. So outside the US then, Luke, what's your expectation in terms of the Bank of England? Are you expecting substantial rate rises in the coming year? How you thinking about that?
Luke Bartholomew 19:31
So well, I the bank has already started, right. So the first interest rate increase went through in December when Omicron was sort of still raging, which I think probably gives you some sense of sort of where the bank's priorities and thinking is at this point, which is to say, you know, inflation prioritisation over sort of playing it safe on the public health. Maybe this is a big downturn that that sort of thinking didn't seem to hold much weight at all and they wanted to tighten And then that was followed up in the meeting just last week with another 25 basis point increase. So interest rates are now at half a percent. And I think what was quite striking about that meeting was less a decision to keep on tightening that was largely expected. But there were four of the nine policymakers who voted for a 50 basis point increase a half a percent increase, rather than the quarter percent that we got. And pretty much no one in the market was expecting that. So that would have come as quite a sudden shock. And sort of a lot of central banking recently has all been about managing expectations and helping investors to understand what their reaction function is to sort of guide financial conditions to where central banks thinks are appropriate to meet their target. So this sort of sudden shock, do a very large increase at the markets not expected that that isn't really or hasn't been in the playbook for a while. So again, sort of speaks to sort of the degree of concern that some of them at least on the committee are feeling and this need to sort of really get out ahead of this thing. So my sense is, it's still pretty unlikely that we'll get a single 50 basis point increase in any one meeting, but we do just now have to be alert to the possibility that the banks could put it on the table as a policy option, even if not a base case, one. And instead, we just see several consecutive further interest rate increases from here over the next two meetings are further to 25 basis points, which will get us to 1%. And 1%, is quite interesting, in a UK context, because the Bank of England has explicitly said that that's the point where there'll be prepared to consider starting to actively sell the assets on its balance sheet and run down QE in that way, and the process that James was talking about with regards to the US then so I think when that process starts, that will cause something of a pause in the hiking cycle, whilst they make sure that, you know, the market is able to digest this process of shrinking the balance sheet and that that doesn't exert more tightening of financial conditions than they want. But the risks are much as James described, they're, I think, very much to the upside. And they find that, you know, they get to 1%, they start QT. And still, they haven't done enough. And so it's definitely possible that you get further interest rate increases this year. And that that, as I say, is very much the direction of risks I think
Stephanie Kelly 22:35
that's again, super, super clear. And I think definitely possible, is probably a mantra that us as economists tend to lean on. In terms of then finally, the ECB. Because I think one of the biggest surprises, you know, in the last, I mean, number of weeks has just been around growing expectations around ECB potentially tightening this year. So how likely do you think it is that the ECB is tightened? And should investors be concerned about this? Is it really significant given the concerns over the past, you know, financial, the post financial crisis era around the Japanimation of Europe? And now we're talking about the ECB potentially raising rates?
Luke Bartholomew 23:17
Yeah, I mean, it's clearly a growing risk. And as you say, it's interesting in that for a long time, you know, there was this sense that, okay, the Bank of England, the Fed are going to start tightening, but don't worry, the ECB, the European Central Bank is still in that bucket with the Bank of Japan, it's hard to see any interest rate increases over your forecast horizon. And then it was okay, maybe you know, the ECB isn't quite Japan, but it's still a very long way behind the Fed of the Bank of England. And increasingly, you know, the direction of travel is very much that the ECB is moving or being dragged is perhaps there's a better way of saying it, given the inflation outcomes closer and closer towards that Bank of England fed camp where they're actually going to have to do something relatively soon. And then the latest signalling from President Lagarde, the last ECB meeting did sound more hawkish than I think some were expecting on sort of current ECB plans, they they're still going to be doing QE until basically the end of this year. And they'd signalled that they wouldn't increase interest rates until they finished the QE process. So if you take that at face value, then perhaps there isn't an increase until 2023. But I think increasingly, the risk and the concern is that at the March meeting, and they have to reassess that, that QE yet ended quicker, or at least certain parts of the QE package ECB, in its rather peculiar setup has like two or three different QE packages that it runs that are all under slightly different rules. But this particular package that came in through the pandemic, they would, they would end that early on, and that would create space this calendar year to potentially raise rates so I think it would be the signal that investors are looking for from the March meeting is whether they're going to speed up or indeed, just rapidly end their asset purchase programme. And if that were to be the case, I think increasingly we'd have to, we'd have to consider the possibility of interest rate hikes this year. We're not at that point. Yep. That seems to be the direction of travel.
Stephanie Kelly 25:21
Sure. Sure. Absolutely. Understood. And then finally, we have obviously left off the Bank of Japan in this concept context. I mean, should we if if the market start to talk more seriously about the BOJ (Bank of Japan) rate hike? I mean, should we take that as a sign that the apocalypse is coming when it comes to inflation environment?
Luke Bartholomew 25:40
Oh, the apocalypse might be a little bit too strong. Yeah, I mean, like all the inflation has, has definitely been a lot more than others. And indeed, we have been expecting the last year or so I think the kind of inflation environment that will be necessary for the Bank of Japan to find itself in this situation is very hard to foresee at this point. And, you know, frankly, the Bank of Japan might think that's a nice problem to have, given they've been the last 30 years.
Stephanie Kelly 26:08
Sure, sure, fine. Finally, they got a bit of a break. So I'm afraid that is all the time we've got for this week. But thanks so much to James and Luke, for your insights for joining us, I'm sure we'll have you back on in a number of months to see how many of those predictions worked out and where the changes came true. Next week, we're gonna be exploring Russia Ukraine tensions and what they mean for investors. So please do join us then.
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