The Calm Before the Storm?

Our Global Chief Economist explains why a predictable end to 2024 for central banks may give way to a tempestuous 2025. ----- Transcript ----- Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist, and today I'll be talking about how the year end is wrapping up with, surprisingly, a fair amount of certainty about central banks. It's Tuesday, December 17th at 10 a. m. in New York. Unlike the rest of this past year, year end seems to have a lot more certainty about the last few central bank meetings. Perhaps it is just the calm before the storm, but for now, let's enjoy a benign central bank week ahead of the holidays. Last Thursday, the ECB cut interest rates 25 basis points, right in line with what we were thinking and what the market was thinking. Similarly, but I have to say, with a pretty different narrative, we expect the Fed to cut 25 basis points this week and the market seems to be all in there as well. The Bank of England, the Bank of Japan, well, we think they're closed accounts; that is to say, they're going to be on pause until the new year. Last week's 25 basis point cut by the ECB came amidst a debate as to whether or not the ECB should accelerate their pace of rate cuts. With most doubts about disinflation resolved, it’s downside growth risks that have gained prominence in the decision making process there. Restrictive monetary policy is starting to look less and less necessary and President Lagarde’s statement seems to reflect that the council's negotiated stance, that easing will continue until the ECB reaches neutral. The question is what happens next? In our view, the ECB will come to see there's a need to cut through neutral and get all the way down to 1%. In stark contrast, there's the Fed, where there are very few residual growth concerns, but there have been more and more questions about the pace of disinflation. The recent employment data, for example, clearly suggests that the recession risk is low. Some members on the committee have started to express concerns, however, that inflation data really have proven stickier and that maybe the disinflation process is stalled. From our perspective, last week's CPI data and all the other inflation data we just got really point to the next PCE print showing continued clear disinflation, leaving very little room for debate for the Fed to cut 25 basis points in December. And indeed, if it's as weak as we think it is, that provides extra fuel for a cut in January. That said, our baseline view of cuts in March and May are going to get challenged if future data releases show a reversal in this disinflationary trend, if it's from residual seasonality or maybe pass through from newly imposed tariffs, and Chair Powell's remarks at next week's press conference are really going to be critical to see if they really are becoming more cautious about cuts. Now, we don't expect the Bank of England or the Bank of Japan to move until next year. The recent currency weakness in Japan has raised the prospect of a rate hike as soon as this month, but we've kept the view that a January rate hike is much more likely. The timing would allow the Bank of Japan to get greater insight into the Shunto wage negotiations, and that gives them greater insight into future inflation. And recent communications from the Bank of Japan also aligns with our view and in particular, there is a scheduled speech by Deputy Governor Himino on January 14th, one week before the January 23rd and 24th meeting. All of that says the stars are lined up for a January rate hike. Market pricing over the past couple weeks have moved against a hike in December and towards our call for a hike in January. Now, the market's also pricing the next Bank of England cut to be next year rather than this year. We expect those cuts to come at alternating meetings. December on pause, a cut in February, and gradual rate cuts thereafter. Now, services inflation, the key focus of the Bank of England so far, has remained elevated through the end of the year, but we expect to see mounting evidence of labor market weakness, and as a result, wage growth deceleration, and that, we think, is what pushes the MPC towards more cuts. All of that said, the recent announcement of fiscal stimulus in the UK starts to raise some inflationary risks at the margin. All right, well, as the year comes to an end, it has been quite a year to say the least. Elections around the world, not least of which here in the United States, wildly swinging expectations for central banks, and a structural shift in Japan ending decades of nominal stagnation. And I have to say an early glimpse into 2025 suggests that the roller coaster is not over yet. But for now, let's take some respite because there should be limited drama from central banks this week. Happy holidays. 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