How high could central bank interest rates go?

Paul Diggle

Hello and welcome to Macro Bytes the economics and politics podcast from Aberdeen Investments. My name is Paul Diggle, Chief Economist at Aberdeen. So there is so much going on in macro as ever. One of the big themes right now is the turn in the central bank interest rate cycle globally - from the rate cuts of 2024 and 2025 to renewed rate hikes from many of the major central banks. We're recording this episode a week or two after some important decisions by the US Federal Reserve, the Bank of England, the European Central Bank, the Bank of Japan, either raising interest rates or seemingly signaling interest rate hikes to come. And it wasn't just the interest rate outlook that was interesting about those various decisions. There were various changes on the balance sheet going on and central banks are increasingly intertwined with politics, potentially threatening independence. So, to discuss our thinking on those central banks, the outlook for interest rate policy and monetary policy. I'm delighted to be joined by Jon Butcher, Felix Feather and Sri Kochugovindan, all from the Global Macro Research Team here at Aberdeen. Jon, let's start with you. Let's talk about the US Federal Reserve. The Fed unanimously raised the Fed funds rate to 3.75% to 4%. It was the first increase since 2023. And you got that call correct. And you were early, I think, relative to the economist consensus in getting that rate hike call correct. Tell us about the decision to hike and what you took away from the decision and the press conference.

Jon Butcher

As you say, the vote was unanimous which is a bit of a change because we have had some dissent within the FOMC over recent meetings. But obviously the upward inflationary pressures seem to have built a broad consensus for action this time around. In terms of the press conference itself, Kevin Warsh was his usual rather opaque self, not necessarily offering up much in the way of how the Fed may react moving forwards but I'd say it was a more polished and well received performance than previous press conferences. What he did say in the press conference was largely what had changed in the inter-meeting period, which led them to make the decision that they did make, and he perhaps gave some tentative indication of some further tightening to come from the FOMC over the coming meetings. So on that why, Warsh was basically a pain to point out the strength of US economic activity, noted the robust investment performance and a balanced labour market. And at the same time, he stressed the lack of improvement in inflation data, specifically that there had been faster than comfortable increases across a broad range of goods and services that make up the bucket of inflation, if you will. The third factor that he mentioned was around geopolitical uncertainty and energy prices. And it was interesting because what he said was that the Fed can't control oil prices, obviously, but it can prevent wider spillover effects. So in that light, I would be inclined to view that decision to hike interest rates as a risk management one, looking to head off the mounting inflation risks that we are seeing and obviously the Fed is seeing as well, and to manage expectations, preventing a wage/price spiral. I think what our current expectation is is for the Fed to make one or two hikes. And at the moment, our base case assumption is for one further hike in December. And that really would be to demonstrate credibility in its resolve to bring inflation back to target. But there are some risks around that view. Of course, the situation in the Middle East is very unstable. And depending on how the oil prices and energy prices develop over the coming months, we could have a different course of action. I think one of the perspectives just to briefly mention though is that some people are suggesting we're at the beginning of a more prolonged hiking cycle now, that the strength of US economic activity and investment in particular would necessitate a longer, more sustained period of hiking of interest rates. That's not our view at the moment, largely because we see this disinflationary trend across a large proportion of US prices still intact. And as long as wages don't really pick up too much from here, that should continue to be the case in 2027. So in some respects, the Fed hiking now and looking to prevent second order effects from the energy crisis is reducing the potential for them to have to hike more aggressively down the line should the economy heat up too much further on.

Paul Diggle

So ‘insurance’ hikes to ward off potential second round effects, not a normal large monetary policy hiking cycle, which we think about as being perhaps at least 100 basis points, on average 300 basis points, of hikes. We're talking here in our base case of 50 basis points of rate hikes. But Warsh is doing this rate hike with the collective decision of the committee seemingly signalling more to come. Not directly, of course, he's very careful not to give forward guidance, but the dots of the rest of the committee certainly suggest at least one more rate hike. Why, Jon, do you think that Warsh has turned out to be somewhat hawkish? Obviously, going into Warsh's chairmanship, there was much speculation about what sort of Fed chair he would be. And there was some speculation that he would be beholden to President Trump - and therefore on the dovish side. Historically he was often a hawk in his past communication. Are we surprised that this is how Warsh has turned out and that he is hiking at his second FOMC meeting?

Jon Butcher

Yeah, it's difficult to say how much of A hawk he has become or is, because a lot happens behind the closed doors of the Fed. And as we've just discussed, he is rather limited in how much of his own view he wants to convey in the public space. But certainly, there is a contrast in his most recent comments versus the comments that he made in the run up to his nomination as Fed chair. I think a cynic might say that at that time he was pandering to his audience to some extent and perhaps saying what he thinks the president wanted to hear to help him effectively in that job interview process. But I would say that's probably a bit of an unfair characterisation, at least to some extent, because the situation now is very different to the situation it was whilst he was going through that nomination process. Remember, back at the start of this year, the expectation was for the Fed to cut interest rates twice in 2026. We didn't have that strong inflationary impulse from AI investment so evident. And of course, the situation in the Middle East and the spike in energy prices wasn't there. So it was a very different situation. And given what has happened in that interim period, I think you could say that Warsh's shift to a more hawkish stance was necessary. And potentially, if he hadn't done so, he risked doing irreparable damage to his credibility as Fed chair right at the beginning of his tenure. Now, of course, maybe that's not what the White House wants to see, but that's the situation that Kevin Warsh has found himself in.

Paul Diggle

Does that bring risk of President Trump interfering in the Fed? And of course, there's a lot of history here, both during the Trump presidency, but going back many presidencies, leaning on, trying to put pressure on the central bank. But those risks have at points seemed particularly acute under the Trump presidency. And related to that, we're recording this shortly after the publication of an investigation into the collapse of Silicon Valley Bank back in 2023 and aspects of that report are particularly critical of one of the current FOMC members. So tell us about what's going on there and if that might give the president a lever to exert control over the Federal Reserve Board.

Jon Butcher

Yeah, the president has been outspoken in his desire to see lower interest rates, obviously. And he talks about the US should have interest rates down at 1% and has been seeking for various different means to get leverage over the decision making process, it seems. So obviously in 2025, we had the action again, the attempt to dismiss Lisa Cook, as well as the investigation into former chair and current governor Jerome Powell. So in some respects, his attempts to put pressure on the FOMC have been thwarted, but it's unlikely that desire has gone away completely. And this report that you mentioned around SVB's collapse potentially gives them another avenue to explore in finding some leverage. Reason being ,that report which was released by current vice chair for supervision, Michelle Bowman, highlighted that there were some severe shortcomings basically in their regulatory and best practices whilst that SVB collapse took place. And that took place at a time when Michael Barr, current governor, was in her position of vice chair for supervision. So basically he was overseeing and directly responsible for that regulatory regime, if you will. And as I say, the report is very critical of what took place during his tenure as vice chair. So potentially there is enough material there for the administration to seek to dismiss Michael Barr with cause. The previous Supreme Court ruling that we had against the dismissal of Lisa Cook wasn't that you couldn't fire an FOMC governor it was that you couldn't do it without following due process. So maybe they now have justification for due process.

Paul Diggle

Would that really shape the monetary policy outcomes of the Federal Reserve if there was a change of one governor?

Jon Butcher

Probably not around the interest rate path itself. I mean, you have 12 voting members within the FOMC. So changing one of them unlikely to have much of an impact unless there is some subconscious weighing on decision makers' thoughts. More likely, though, it could lead to an acceleration in deregulation in the banking sector, something which Michelle Bowman has been very keen to advance. And Michael Burr, in contrast, has basically been in favour of a more strict or tighter regulatory regime. So his removal could allow some faster deregulation, which in turn potentially leads to changes in bank liquidity and reserve requirements and ultimately lead to banks holding less reserves at the Fed, which means the Fed holds less assets, which is something which Kevin Warsh has expressed a desire to do through and is being looked at in one of his task forces.

Paul Diggle

Great. So Felix, let's talk about the Bank of England and then the European Central Bank. The Bank of England at its latest meeting held the bank rate at 3.75%, but your interpretation is that they were laying the groundwork for future tightening. So tell us about the decision, the press conference and the outlook for UK interest rates.

Felix Feather

So as you say, it was another hold from the Bank of England and it's now the last major developed market central bank not to have hiked rates even once in response to the energy cost shock that lifted off in the earlier part of this year. The vote split here is interesting. So of the nine members of the Monetary Policy Committee, 6 were in favour of a halt, and three voted for a hike. That's the same vote split that we saw in July. But interestingly, the bank's chief economist, Huw Pill, was among the dissenters. He was voting for a 25-basis point hike, justifying his decision with a more inflationary outlook for the economy. Why I think this might be laying the basis for a hike in November, which is the next meeting, lies in the individual statements of the nine members of the MPC. So four of those, the four remaining internal members of the MPC that are not Pill, did mention that rates might need to go up in the future. They cited the building cost shock of higher energy prices. They cited the potential for second round effects, perhaps through the wage channel. And they cited strong demand for investment globally coming from an AI-driven super cycle. That to me says that there should be the numbers there to move rates higher in November. This makes perfect sense. If oil and gas prices follow the kind of path that is implied by market pricing at the minute, then we can expect inflation to reach maybe 4% by Q1 next year in the UK. And that for me, I think justifies an additional hike. So we've got two hikes now, not just in November, but also following that up with another hike in February. The reason this is happening at a quarterly cadence is because the Bank of England only gets to update its forecasts and hold a press conference once a quarter. That will come in November. So it's a natural point to begin a hiking cycle. And then the next meeting in December is a natural point to take a breather, have a hold. And then February, when we can update the forecast once again, hold another press conference, that's another point to take the hiking cycle to what I think will be its end, taking bank rate to 4.25% at that point and holding it there for most of 2027 at least.

Paul Diggle

Great. And already some clear common themes between central banks emerging there. In particular, there's obviously this inflationary shock from the run up in oil prices and broader commodity prices. But as Jon was saying, central banks don't have direct control over energy prices. What they do have, though, is the ability to contain second round effects. And, you know, both yourself and Jon were using that language and reflecting that the central banks themselves are increasingly concerned about second round effects in the absence of actually seeing them in the data as well. It's a hawkish reaction function shift that they're no longer willing to risk waiting for them to emerge. They're potentially already acting and in Bank of England's case, potentially acting to contain those second round effects. But one of the other areas of action at the Bank of England meeting in September was around the balance sheet. Now this can be a little bit esoteric, but it matters. It matters for financial markets and bond markets. Tell us what the Bank of England did on the balance sheet this month, Felix, and how we should be thinking and interpreting those changes.

Felix Feather

So it might be worth quickly explaining what the Bank of England was doing before this meeting. So most major central banks have a lot of government bonds on their balance sheets at the minute. That's because many were bought up in response to the global financial crisis and then perhaps even more so in response to the COVID crisis of 2020 and the period of ultra loose monetary policy that followed. Most of these central banks are running them off passively, i.e. waiting for these bonds to expire. But the Bank of England is doing something a little bit more active, actively selling these gilts, UK government bonds, in the open market to get them off the balance sheet and normalise monetary policy into something more like a non-emergency state. However, this has put a lot of upward pressure on UK gilt yields. As the price falls, the yield must rise. And we've seen this particularly hurt asset prices at the long-end of the curve. So the UK 30- year gilt near 6% nominal in the run up to this meeting. And the Bank of England was estimating that the QT programme, the quantitative tightening programme, that had been running was adding a good 0.25% or above onto those gilt yields. That's not the intention of this programme. So the QT programme had to be scaled back somewhat. We and most economists were expecting that it would be scaled back from a pace of around about 70 billion per year in runoff to about 50 billion pounds per year reduction of the balance sheet per year. We got slightly more than that. The Bank of England decided to reduce its runoff of bond holdings to 46 billion pounds a year, so 4 billion less than expected. But probably the bigger changes were even more idiosyncratic than this. So the bank ceased active sales at the very long end of the curve. So bonds maturing after 2049 will no longer be sold on the open market. And moreover, the sales that do happen will be, pending approval from the Treasury, will be bundled with standard DMO auctions. So the Bank of England auctions and the Treasury's auctions of fresh government debt are not in competition with one another. Taken together, these measures were taken really quite well by markets. After flirting with 6% earlier in the week the UK 30-year yield is now down to more like 5.7%. It fell 12 basis points on the decision alone. I don't think there's anything political going on here. I don't think there's any political interference, but it does have the positive side effects for the government of making the cost of borrowing at the very long end of the curve, a little bit cheaper coming into the Budget. Still, I think the majority of the headroom that the government had at the last update of the OBR's forecasts will have been eroded away by now.

Paul Diggle

Yeah, nothing necessarily political going on because the bank was an outlier, as you said, Felix, in actively selling bonds rather than just allowing runoff from maturing bonds. So even just correcting that abnormality, that was part of what was going on there, it need not be political, although clearly, as you say, it doesn't hurt ahead of what's going to be a very difficult budget. But let's talk about the European Central Bank then as well. So it raised its interest rate to its main policy rate to 2.5%, its second hike of this tightening cycle. Tell us about the ECB's thinking and outlook there.

Felix Feather

So it is a little bit interesting that the ECB is so much further ahead than some of its peers in its tightening cycle. Its inflation rate at the very least came from a lower starting point than than it did in the UK, for example, and indeed the US for that matter. However, I would contend that ECB policy was a little bit looser to start off with. So in bringing rates back up through the twos, the ECB is normalising policy and catching up to maybe where it should have been already. So there were two justifications for the ECB's rate hike at its last meeting. One was higher inflation forecasts. ECB's mandate is for a 2% inflation target. That's harder to reach with a major energy cost shock underway. So a tightening of policy was in order. But two, and this is an interesting one, was that the growth forecasts were upgraded quite a bit as well. And that's come from more resilient than expected bank lending, better private sector investments, all things that we thought might struggle a little bit in response to the real income shock that households and firms are facing from higher energy prices, higher rates expectations. But no, the eurozone economy has been continuing to record a round about trend rate of growth. That tells ECB policymakers that they can actually raise rates a little bit without triggering immediate recession risks. Looking forward then, I don't think the ECB is done either. As with the Bank of England, we see it moving at a quarterly cadence going forward, and that continues the quarterly pace of hikes that we've seen coming so far. So a hike in June was followed by a hike in September, and we see one coming in December when inflation in the Eurozone will probably peak, also probably around 4% or just a little bit lower. But I think there's enough there for a hike in March as well. That's partially about expectations for strong fiscal easing in 2027 and 2028. It's also about above target inflation and surprising resilience on the growth side.

Paul Diggle

How should we think about the political context of the European Central Bank's decisions, Felix? And in particular, there's obviously a lot of focus in markets and macro commentary at the moment on what's been happening in German politics, German federal elections, but I think it's really the upcoming French election in April next year that perhaps matters most of all for the immediate ECB decisions in the context of the spread of French bond yields over German yields now being quite large, 100 basis points or so. And there's an ECB presidential race to come at some point or contest because Lagarde's term is up late next year. So what's the political setting here or considerations?

Felix Feather

Well, you're right that there's a lot going on. Let's start with the French presidential election. There are probably fewer more stern critics of the ECB in the Eurozone than can be found in the leadership of the National Rally. And if that party does come to power, it raises some questions for the ECB. Jordan Bardella, who’s a key leader for the National Rally, has repeatedly called for France to stop paying its interest payments on debt held by the ECB. That's clearly something that the policymakers at the ECB would be willing to push back against. And you also mentioned the role of President Christine Lagarde, previously a prominent figure in French politics. She'll be wanting to make sure that the French political calendar does not interfere with the smooth transmission of monetary policy. But there's also this question of when she leaves her position. All we have from her at the minute is that she's committed to leaving in 2027. Well, that seems pretty much a foregone conclusion. Her term expires in October 2027, so that's when you'd expect her to leave, but she's been linked so often with leadership roles at the WEF that it's widely expected that she will leave before that time. She might want to leave her position before the French presidential election to make sure that a potentially populist president of France doesn't have a role in appointing her successor. These processes though involve a lot of horse-trading and the choice of the next president probably depends on who's going to be taking up other major leadership positions at the ECB next year because the chief economist position and a position on the executive board is also up for grabs next year. These will be no doubt subject to discussions between Europe's leadership as we speak. How this feeds through into policy is difficult to say. Perhaps a more dovish president of the ECB might look to scale back some of the ambitious changes to its operational framework, which involves reducing the balance sheet and removing government bonds from its structural portfolio and something which perhaps has put a little bit of pressure on government debt, especially in places like France. Whereas if a more hawkish representative of Northern Europe, perhaps the current Bundesbank President Joachim Nagel comes in, well then it's possible those initiatives are accelerated and markets might look to price in a more hawkish rate path for the ECB as well.

Paul Diggle

So Felix, last question to you then on ‘R star’ - the long run equilibrium or neutral rate of interest - which is a theoretical concept where we think that monetary policy would be neither tight nor restrictive and where we think it might settle in the long run. Now, Jon, I note that in the latest Fed press conference, Kevin Warsh was really playing down the operational usefulness of the concept of R star. But nonetheless, in financial markets, in our own forecasts, in the dots of the Federal Reserve, you see, and we've seen it recently an increase in the terminal rate where interest rates are expected to settle in the long run. Felix, what is driving that and why might the long run equilibrium rate of interest be increasing?

Felix Feather

Central bankers are often reluctant to be drawn on questions about the neutral rate of interest because markets want to take the answers to those questions as indications about what they should be pricing for rates over the long term, which is maybe an overreading of what central bank might want to communicate to its audience. However, for us as people who are concerned with what asset prices are going to be doing over the medium term, these questions are incredibly important and we need to engage with them in an intellectually rigorous way. I see a couple of reasons why you might want to motivate a higher R star at least over the short term. So one is that we are seeing structurally more demand for financing. And that's coming from governments looking to widen their deficits for things like investment in defence, investment in infrastructure, investment in green technologies, and that's all going through the private sector as well. But now we have another massive driver coming online as well, which is the AI investment boom, which has been key to driving US growth and has had a huge effect on the global economy already. That's pushing up on demand for financing as well. We’ve also not seen so much of a savings glut that characterised the 2010s that was supported by high savings rates in exporting countries especially, so your China's, but also in places like the eurozone. All of that means that you need a higher real rate of interest to induce people or economic agents, be they in the public or private sector, to save instead of borrow. So that means that in equilibrium, we should be expecting rates to be slightly higher over the medium term. This is a global concept. So it affects our Bank of England call, it affects our ECB call, it affects our Fed call, and also our bank of Japan call as well.

Paul Diggle

It's a big sea change, structural change in global savings and investment balances. And I think this move from a global savings glut that characterised the era of very low interest rates to an increasing competition for savings as we are running very large fiscal deficits, but also now seeing a large amount of corporate issuance to fund the AI build out. Really big underlying structural change going on there that's going to impact monetary policy. Sree, let's come to you now and talk about the Bank of Japan. It raised its policy rate to 1.25% at the latest meeting. Tell us about that decision what you took away from the press conference and the outlook for the Bank of Japan from here.

Sree Kochugovindan

Yeah, so the decision was fully priced going into the meeting. So that's the first thing. And they did deliver. They delivered a 25-basis point hike because they raised rates to 1.25%. So that's the highest since 1995. And that follows on from a fairly slow pace of hikes so far. So the last hike was in June this year and then prior to that was December at the end of last year. So it's comfortably, BoJ is comfortably, picking up the pace of hikes now and they've signalled that in the statement and the press conference. But there were some divisions within the board and that was worth noting, we can talk in more detail later, but there was a 7-2 vote split. The 2 new appointees preferred to keep votes steady. And then on the hawkish side, there were two members that said that they didn't agree with the economic assessment and they argued that underlying inflation... is already consistent with 2%. It's not approaching, it's already consistent. So there was a split there within the board. But otherwise, the statement, the inflation language was sharpened quite a lot. So underlying inflation is still described as approaching 2%, but they're talking more about wholesale price pressures, the pass through to consumer prices. That was a question mark before, but now they're seeing evidence of this - rising wages, inflation expectations, all of this put together, they actually say is leading to the risk of an overshoot in inflation, not just reaching target, but overshooting for a sustained period. So that was a lot sharper. And then in the press conference, there was an important message in that the BoJ policy phase has now changed. So whereas previously they sought to lift underlying inflation towards 2%, now the bank wants to prevent an overshoot. So that indicates faster pace of hikes. What else did he say? He was hawkish at the beginning of the press conference, Governor Ueda, but then he shifted, very typical Ueda style, he shifted to a little bit of caution, he said, you can't tighten too quickly because you don't want to disrupt financial prices. Markets can't adjust too abruptly. And I agree with all of that. However, during that press conference, you could see price action shifting. So the wording was hawkish, but the interpretation that was taken away from it all was a bit dovish. And you could see that in terms of the yen weakening. It weakened, it rallied a bit and weakened again during the press conference. So overall, I think markets were not that impressed. But I do expect a faster pace of hikes. So the next hike I'm looking looking for is December and then again another hike for 2027 which is probably in April and I think at least two more hikes. There is potential for more hikes as well. I think the October meeting, even if you don't see a hike, I think hawkish tone will be important - expect those. We have an outlook, economic outlook, being published that month. So look for some upgrades there and a hawkish tone within the outlook. So that's the overall view. Faster pace, more hawkish tone. The markets need to believe it though.

Paul Diggle

As you say, that notable difference between your interpretation of it being quite a hawkish statement and press conference, at least in part, and that market pricing, which sort of fell away a bit, and you saw some yen weakness during and after the press conference. And in addition to some of that communication from Governor Ueda, One of the things it seems to me the market was focusing on was the vote split, as you highlighted, and the fact that these two newer appointments, appointees of Prime Minister Takaichi, voted to hold. And there's perhaps the start of concerns about politicisation of the Bank of Japan. And there are more appointments coming in the future, right, that may add to that dovish shift within the committee. So should politicisation be something we're talking more about in the Bank of Japan context? Is that a worry or a threat to independence going forwards?

Sree Kochugovindan

I do think of it as a worry, actually, and I noticed that in June as well. So the two people, as you mentioned, the two people who dissented, they are Toichiro Asada and Ayano Sato. So Toichiro Asada, in June, in his very first meeting, voted to dissent. So we had a hike in June. He was the only member that voted to keep rates on hold. And that's actually unusual for any central bank, for somebody to dissent in their first meeting is unusual. And particularly for the BoJ. I think that's culturally, I'd say that's quite different. So that was a signal. And now you see again, Ayana Sato voted to hold this time as well. So joined Asada in that vote. She only joined in July, July the 1st. So again, an early dissent there. We have two more. appointees next year. So the two of this year, they're both reflationists, both academic, both doves, chosen by Prime Minister Sanae Takeichi. There is a shift within the BoJ happening. We also see in 2028, Governor Ueda's term end. So there's yet another very important shift happening longer term. So given all of this, given that what we saw in June, that was enough to signal to the market that there is a political dimension here. So the window for hiking has narrowed. And at that point, I did bring forward my outlook for rate hikes. And because we have, first of all the political backdrop, but then we also see, we have the Middle East tensions in the background. Wage growth is picking up. But the headline inflation has been decelerating this year. We need to look at what's driving that. That's the base effect from very high food prices. It's a legacy. So that disinflation is dragging headline lower. But also we've seen government fiscal support for households, subsidies that are dampening the impact of the Middle East tensions. So the actual inflation numbers are still relatively subdued, but the underlying domestic pressures are picking up. And that's exactly what the Bank of Japan have been waiting for in terms of policy shift. And that is all coming together now. So I very much agree that there is a political shift happening and it does narrow that window. Hence a faster pace will be needed to convince the markets as well.

Paul Diggle

So a window of opportunity to hike both given the what's driving inflation up and down in different ways and those that political change as well coming to the board. Okay, brilliant. Jon, Felix, Sree, thanks very much for joining and thank you to you for listening to Macro Bytes. As ever, please like and subscribe to the podcast on your platform of choice. But until next time, goodbye and good luck out there.

This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for information purposes only and should not be considered as an offer, investment, recommendation or solicitation to deal in any of the investments or products mentioned herein and does not constitute investment research. The views in this podcast are those of the contributors at the time of publication, and do not necessarily reflect those of Aberdeen. The value of investments and the income from them can go down as well as up, and investors get back less than the amount invested. Past performance is not a guide to future returns, return projections or estimates and provide no guarantee of future results.