La fin du commencement ?

• We expect a slower pace of tightening from December 2022 from the Fed and the ECB. Market optimism could however be curbed by the realization that a slower pace does not necessarily inform on the “terminal rate”. There will be more episodes of stress amid volatile dataflows.

The “end of the beginning” of the ongoing monetary tightening will be reached when central banks intend to continue hiking but decide they can take the risk of doing it at a less brisk pace. We expect both the Fed and the ECB to resort to a smaller quantum of tightening at their December meetings after delivering a last 75bp move, the Fed emulating the ECB this week. Yet, there is not direct link between slowing down and finding the right level of the policy rate which will be appropriate to return inflation back to 2%. The “terminal rate” remains elusive. It’s just that the risk of fuelling more overheating is now lower, so that the central bank can now move to a “probing strategy” rather than “catching up” in a hurry.

While the “probing” approach reduces the risk of policy mistakes – and from this point of view we can understand some of the market’s recent bout of optimism – if the resilience of the economy holds up into the coming months, the Fed may be forced to go further than the 4.6% median forecast of the FOMC members for Fed Fund in 2023. Still, for our part, we remain comfortable with being slightly below market expectations for the terminal rate given our forecast of a sizeable recession in the US driven in part by the ongoing steep deterioration in financial conditions, but we also expect more episodes of market stress in the months ahead every time the dataflow will not move down “fast enough”. Besides, investors need to accept more “macro pain” ahead before enjoying the benefits of a proper “dovish pivot” by the Fed. In the Euro area, a higher-than-expected inflation print for October released a day after a less “one-sided” Governing Council meeting may have wrong-footed the ECB. There remain strong reasons though to still expect a sizeable deceleration in inflation next year, converging to the central bank’s target. Yet, beyond the number and size of the next hikes (we now expect 50bps in December and 25bps in February) we suspect the bond market will become increasingly sensitive to the prospect of Quantitative Tightening, with a decision on this now scheduled for December. The Bank of England also meets this week. We stick to our view – and now the market’s – that 75bps would be a good “compromise hike”.