War complicates central banks’ path

Transitioning into the year 2022, major central banks seemed to be sticking on to their plan to tighten policies. One example is when the Bank of England (BoE) raised interest rates for the second time in three months on Feb 3 to contain surging inflationary pressure

AFTER a spectacular yet fragile recovery made by global economies from the adverse effects of the pandemic, central banks’ hawkish sentiment dived towards the end of 2021 when inflation hit multi-year highs, beating market forecasts and triggering alarm for central banks.

Transitioning into the year 2022, major central banks seemed to be sticking on to their plan to tighten policies.

One example is when the Bank of England (BoE) raised interest rates for the second time in three months on Feb 3 to contain surging inflationary pressure. Interestingly, four out of the nine members of the bank’s monetary policy committee voted for a much more aggressive hike of 50 basis points (bps) while the rest voted for 25bps, which underpin how serious the inflation was and how badly it needed to be contained.

As of time of writing, the BoE’s official bank rate stood at 0.50% after increases of 15bps and 25bps.

Coincidentally, the European Central Bank (ECB), which was widely seen as one of the last remaining central banks that hold a dovish stance aside from Bank of Japan (BoJ), also struck a significant hawkish tone at its key meeting, which also happened on the same day.

It was induced by higher-than-expected eurozone’s inflation data released on the previous day where the pace of consumer price rose to 5.8% from 5.1% in the previous month, a new all-time-high record for the eurozone.

With ECB president Christine Lagarde refusing to reiterate that it is very unlikely the interest rate hike will happen this year, the hawkishness was further bolstered by some members of the ECB’s governing council who were already expecting the rate to increase by the last quarter of 2022. And as expected, the market reacted accordingly – European yields jumped and the yield curve flattened.

Looking at the other side of the Atlantic, the US Federal Reserve (Fed) joined the hawkish bandwagon as several officials emphasised that a March rate hike was certainly possible, with some pointing out that four rate hikes this year still made sense. A few even suggested the possibility of a full percentage point hike by June’s meeting, which the market has fully priced in early February.

Despite the apparent market volatility that seemed to be caused by the Omicron outbreak and the market’s high expectation of an imminent tightening, Fed officials seemed unmoved by them.

Unfortunately, Russian President Vladimir Putin’s invasion of Ukraine has added an extra layer of complexity to the decisions these central banks are now facing.

While trying to manage higher inflation, originated from surging commodity prices and supply chain disruptions, they now have to factor in the risk of policy mistake in case the urgency of lifting rates could amplify slowing economic growth.

Our initial projection was that the global recovery projection will be uneven and slower to 4.3% (base case scenario) following a strong rebound in 2021 of 5.9%.

As countries with fragile economic foundation would again struggle against the new Covid-19 variant, the prospect of tightening could very well move capital towards more attractive yields out of emerging markets.

Considering Russia is the world’s top exporter of crude and oil products at 7% of global supply and also the world’s largest grains, fertilisers and other commodities such as palladium, nickel, coal and steel, a slight disruption on these products will hit a wide range of industries with oil markets being the most prominent one.

We can already see the market pricing in the possibilities of significant oil shortages when the global benchmark Brent soared recently to a near 14-year high of US$140 (RM587.23) per barrel after the West considered banning imports of Russian oil, although, it quickly dropped 13% a day later. Also, all other commodities have been rising as well since the start of the war on the back of fears on a fallout from the conflict.

With the war risk factor and the potential spillover effects coming into the scenario, it will likely produce uncomfortably slower growth just as central banks unveil their normalisation plans.

Furthermore, they may have to take a step back, alter their plans or even pull the brakes on their normalisation in the wake of the heightened uncertainties as any misstep in treading the process could spell mishap for the economy that they may never recover from.

This is especially hard for the 25-member ECB’s governing council seeing that now they have to weigh the impact of the war that is close to the eurozone and the fact that 26% of European Union’s oil imports and 40% of gas imports come from Russia.

Indeed, central banks have to contemplate their decisions as signals and prerequisites of stagflation are starting to mount and materialised. For example, on Thursday, the US inflation rate came in as a shock again as it accelerated to 7.9% year-on-year for February, which marked the highest level since 1982.

Although the figure was within the market’s expectation, we have to keep in mind that this figure does not fully capture the recent oil bull shock after the Russian invasion. The impact will be clearer in the March Consumer Price Index report.

Also, some market players are already projecting the headline reading to reach 8% throughout 2022. The report also showed that the gasoline price rose by 6.6% from the previous month, which will raise the cost of doing business and reduce production.

Also, in the same day, the ECB decided to end its net asset purchases in the third quarter of 2022, should incoming data “allow” them to do so. It opens the door of flexibility for them to adjust their policies accordingly without having to pre-commit to the direction of the policy. All the more reason to attribute this shift of views by the ECB on the volatilities and uncertainties that the war has ignited.

But we believe that the end of net asset purchases in third-quarter 2022 is still somewhat conditional. It depends on economic developments. It is not a done deal as the ECB also remarked that net asset purchases could still be extended or increased if inflation projections fall below 2%.

Incoming data could pose a shock to the Fed during its upcoming meeting next week. Initially, the expectation was that the Fed will increase interest rate by 50bps during its March meeting. But when the war started, we cut back our projection to 25bps and four instead of six rate hikes with intermittent pause in between to allow them to reassess the situation.

This is to prevent a similar situation back in 1970s where the Fed raised the federal funds rate to 10% which then led to a recession. A higher inflation figure compared to the previous months could only add more headaches for the policymakers.

Similarly, we may see the same cautious tone by the BoE’s policymakers this year. Traders have dialled down their expectations for an aggressive stance since the invasion and are now expecting the benchmark rate to rise to around 1.50% instead of 2.00% previously by the end of 2022.

This is further bolstered by BoE deputy governor Jon Cunliffe’s statement on worries that the war may hurt growth, trigger a drop in value of risky assets and increase uncertainty. Nonetheless, in our view, a 25bps rate hike during the March meeting remains in play.

On the other end of the spectrum, we do not expect any change in the BoJ’s dovish stance as long as its inflation rate remains far below its 2% target and wage growth remained subdued. Just this week, its governor Haruhiko Kuroda dashed hopes of a tightening policy in dealing with cost-push inflation as he emphasised that wage growth needs to pick up first before anything can happen.

This is depite the upwardly revision the BoJ has made in its recent quarterly prices outlook to 1.1% from 0.9% for the fiscal year 2022. It led us to believe that its key interest rate will remain unchanged in parallel with the lower-than-targeted inflation rate.

On the local front, we maintain a 60% chance of a one 25bps rate hike in the second half of 2022.

Moving forward, we expect most global central banks will be cautious in executing their normalisation plans amid the conflict between the Western allies and Russia. Even more so after the West imposed multiple hard sanctions on Russia to prevent a further escalation of the conflict.

In the worst-case scenario, we do not rule an escalation to a full-fledged nuclear war as Putin has already put his nuclear squad on high alert since Feb 27.

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