The Strategist

Monetary policy at a crossroads

In the coming weeks, the major Western central banks - first and foremost the US Federal Reserve (Fed), but also the European Central Bank (ECB) - will inevitably find themselves at a crossroads in the fight against inflation. They face a bipolar choice between confidence in the measures taken or the conventional crowbar.

Thomas Wille
Reading time
10 minutes
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On the one hand, the G7 central banks have the choice of relying on the most aggressive monetary tightening in 40 years and hoping that the economy will cool down further in the coming months due to the proven "time lag". This should dampen price pressures, and the economy should weaken further. The big question remains one of timing: how much patience the Fed will have and how much the political environment will allow. On the other hand, there is also the possibility of taking out the crowbar to achieve the 2% inflation target by any means necessary, thereby accepting a severe recession. Over the summer it will become clear which central bank will choose which option at the crossroads. We expect the crowbar to be used only if inflation reaccelerates significantly. As long as headline and core inflation continue on a trend of deceleration on a quarter-on-quarter basis, central banks will trust the aggressive rate hikes of the past 18 months or so.

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Patient pause at full employment?

Central banks are at a crossroads, with no sustained easing of wage inflation in sight. The first cracks are appearing in the US, but they are too small to give the all-clear. A patient pause could become a test for central banks. "Smaller" central banks such as the Reserve Bank of Australia have had to turn the interest rate screw again because of the tight labour market, and the Bank of Canada had to raise rates again after almost half a year because the economy was too "hot".

The Fed remains the benchmark

Without wanting to be arrogant or relegate other central banks to the background, the focus is and remains on the US Federal Reserve. Its interest rate policy not only affects the most liquid market - US government bonds - but also has a massive impact on the US dollar. Investor expectations of the Fed's future interest rate path have been extremely volatile in recent months. There have been expectations of almost everything from further hikes to just below 6% for the Fed funds rate to a 150-basis-point cut by the end of 2023. In our baseline scenario, we maintain our view that the Fed will remain patient in the coming months and will not need to raise rates above 5.5%. Furthermore, we do not see any potential for rate cuts.

Selection beats allocation

In this environment, selection will remain the trump card for investors in any asset class. As described in our mid-year outlook, we see these opportunities in the following markets:

  • Equity market: Defensive quality and punished cyclicals
  • Bond market: Fallen angels
  • Alternative investments: Market neutral
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