Paul Diggle: Hello and welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Paul Diggle.

Luke Bartholomew: And I'm Luke Bartholomew.

Paul Diggle: And this week we are talking about some of the world's major central banks and their thinking around inflation and the outlook for interest rates. We're in an exceptionally interesting period in terms of central banking. The US Federal Reserve, the European Central Bank, the Bank of England, all in recent meetings inched closer to possible rate cuts later this year. But there are plenty of uncertainties along the way, both about the timing of the first rate cut and the extent of any subsequent cutting cycle. And then away from those three kind of major central banks, we've seen a cut from the Swiss National Bank, it became the first of the so called currency major central banks to pivot to rate cuts, Banxico, the Central Bank of Mexico has done rate cuts, meaning that the cutting cycle has broadened out in Latin America. On the other hand, there's been a surprise hike recently in Taiwan, and then Turkey just hiked 5% to the dizzying heights of 50% interest rates. And then quite different from some of those rate cuts, the Bank of Japan very recently exited negative interest rates in a pretty milestone decision. So, we're going to dissect the Bank of Japan and the Fed on this podcast and we're joined to do that by Sree Kochugovindan, welcome, Sree.

Sree Kochugovindan: Hi, Paul.

Paul Diggle: And James McCann, welcome, James.

James McCann Hi. Thank you.

Paul Diggle: So Sree, let's get into the Bank of Japan, first of all. So at the end of last month, they hike interest rates out of negative, but why don't you tell us some of the other policy decisions they took, and how they changed the settings of monetary policy in Japan?

Sree Kochugovindan: Yes, it was quite a busy meeting. So the Bank of Japan, the BoJ, voted seven -two in favour of ending quantitative and qualitative monetary easing framework. And this includes a number of different factors. So first of all, they originally had negative interest rate policy where rates were held at minus 0.1% - minus 10 basis points- and that was part of an existing three tier policy rate system. Now that was completely replaced. And that was replaced with a single rate and they restored the unsecured overnight call rate. And that was the main policy target. And that will become the main policy tool. And here you have a window - a range - of zero to 0.1%. So there’s a corridor, there for the overnight call rate. So that's one part of the policy move. The second part would be yield curve control - your YCC. And this was originally targeting the 10-year, Japanese government bond yield at 0%. And that had a soft ceiling, a reference rate of 1%. Now, within that JGB purchases will continue in broadly the same amount as before. So the Bank of Japan had been purchasing 6 trillion Yen's worth of JGBs, tenure JGBs, per month, and so that will continue. And it will increase purchases if it sees necessary, and if there is a rapid rise in long-term yield. So that remains in place. But the official Yield Curve Control has been removed. They also ended purchases of exchange traded funds, and Japanese REITs or real estate funds, equity baskets, and this had originally been put in place to encourage risk taking now that has ended. They actually haven't been purchasing ETFs or REITs for a few months. So, ETF purchases ended around October 2023 was the last time they'd actually intervened in that market. And REITs, the last time they purchased was June 2022. But this has now officially ended. And they will also eventually wind down their corporate bond purchases and commercial paper purchases as well. That will be a gradual pace of reduction and they'll completely end it within 12 months. So that was one set of policies. They also changed some of their wording within their communication. So, the overshooting commitment was removed from their statement. So the original wording was that the Bank of Japan would expand the monetary base until core CPI ex-fresh food was stable and above 2% year on year so that overshooting commitment has been removed, and also the prior forward guidance statement that refer to additional easing measures if necessary, that was replaced with references to the current economic outlook, and that expectation is  that accommodative financial conditions will be maintained for the time being. So, we still have very, very loose monetary policy relative to other central banks, but that guidance has shifted. Now within all of that I mentioned earlier that the vote was seven in favour and two against. So the two dissenters, they both voiced their concerns over the weakness of the economy, and their, you know, concerns over the sustainability of inflation pressures. So, there were two who voted against but overall, there was a quite a big change in terms of the package and that quantitative and qualitative monetary, or QQE as we call it, for Japan. So, a big change there.

Paul Diggle: Great. So, these are really important shifts in a more hawkish direction, exiting negative interest rates, but policy is still overall, we couldn't characterise it as tight, it's nowhere near where policy rates have got to in another central banks. What was the reasoning and what's changing in the Japanese economy, and in markets that encourages this kind of big, big shift?

Sree Kochugovindan: Now, the Bank of Japan, if we look at their policy aim, they're looking for a virtuous cycle where higher prices feed into higher wages. And then in turn, you have a feedback loop with higher wages leading to higher prices. And so they really want to see this solidly established and self-sustaining. Now, in the press conference, the justification for all the policy moves, really centred around the recent Shunto wage negotiations. Now, we know that inflation has been very, very strong in Japan, as it has been elsewhere, but there's a question mark, given how fast it's decelerating, given that they still have a negative output gap, whether or not this can be sustained. Now in the press conference, and also in the summary of opinions that were published afterwards, the real focus was on the strength of recent wage negotiations. And that this is actually providing a strong backdrop for the policy shift. They do believe that NIRP, or negative interest rates, has now finally served its purpose and is no longer necessary. And really, you can look at the first round of Shunto wage negotiations - they were the strongest in 30 years. They were much higher than expected by markets, by the Bank of Japan. And they were averaging at 5.3% in total. Last year, which was also very strong, that was just 3.8% of a wage hike. So again, far exceeds market expectations. The base pay hike, that's quite important, because that ignores the regular sheduled pay rises. And that came in at 3.7%. Last year, they only saw 2.3%. So, this is quite a substantial, quite a punchy number. Yes, there could be some downward revisions, there are several rounds at time of recording, it's still quite strong. But we do have another round of revisions that are likely to be announced. So, as the smaller firms start to announce, you can see a downward revision. But it looks at the moment with some of the headlines that this could settle somewhere close to about four and a half percent, which again, very, very good from from the BoJ’s perspective. So even though it's trickier for smaller firms, this four and a half percent on aggregate would be quite positive. There are labour shortages. So, this implies that firms are likely to follow through on these wage promises. Now, that's something that was a disappointment last year, where we saw fairly strong initial wage announcements. They didn't actually feed through into realised earnings, and that was something that the Bank of Japan had been waiting for. That still hasn't happened. But the main focus was really on this year's Shunto, they're not necessarily going to wait for realised earnings to pick up because that could take some time. And if you remember, back in January, they talked about looking at a wider range of indicators, not just earnings numbers, but also quantitative and qualitative indicators as well. So that would include a whole range of headlines, wage negotiations, also regional bank reports and so on. Now, in the press conference at the March policy meeting, Ueda, Governor Ueda, expressed confidence that the small and medium enterprises, that their wage negotiations should continue. But he also stressed the importance of maintaining accommodative policy stance, and he also stressed the fact that you cannot be certain about the sustainability of inflation pressures. So, he does acknowledge that there is still some distance for inflation expectations to be consistent with 2% target. It was quite a neutral, nuanced statement overall, quite realistic, but the main justification would really be the wage negotiations that we've seen so far. So, they've decided to strike while it's hot rather than waiting for further data to evolve.

Luke Bartholomew: So, Sree, I'm interested in the in the market reaction to the decision, because we've already called it a big milestone decision and an important shift in monetary policy. And I guess there was a view for a long time that in a sense that this was a linchpin to the global rates complex, the combination of negative interest rates and yield curve control was suppressing interest rates and interest rate volatility across the whole world. And so the thought might be that once this was lifted, it would have quite significant reverberations across the entire global rates market. But as is, that didn't seem to be the case at all. And perhaps in some ways, that's testament to the Bank of Japan's communication efforts over the last 18 months that they've been telling the market for a very long time that they are going to be lifting yield curve control, that this is the direction that they've been heading. They've been making baby steps as they've gradually shifted the parameters of yield curve control. And by the time the decision came, it was sort of taken as no big deal, no surprise, by the market. But I'm wondering if that's almost swung a little bit too far in the sense that the market did seem to take it quite dovishly. The yen, the Japanese currency, has continued to sell off or at least be weak. So, will the Bank of Japan be happy with how the markets responded to this decision?

Sree Kochugovindan: I think it really depends on the scale of the move, right? So, if you look at rates, as you mentioned, this has been very well communicated. And this was pretty much priced in. But bearing in mind that at the time of recording, we're seeing a bit of a bond rout globally, the Japanese government bonds have barely moved and in response to BoJ and in response to the overall bond sell off. So that's quite good. We have previously had a ceiling for 10-year yields at 1%. And it's been pretty much around 76,75 at the moment, 74 basis points. So that's been quite stable. What has really been a bit of a disappointment, I think for not just the BoJ, but also for the Ministry of Finance, and for the government would be the moves in the yen. And in particular, the yen relative to the dollar. I mean, the yen has been weak relative to euro sterling as well, but specifically to the dollar. And it's really that this carry trade is very much alive and well. And it's that differential in rates between Japan and the Fed and the policy terms, but also in terms of bond yields, you know that given the recent sell off in treasuries, I mean, this is becoming very difficult. So, the policy move that we saw in March, it was, you know, it was quite big from the list of announcements, but ultimately, it's just a 10 basis point rate move. And that's not going to meaningfully shift anything for the yen. So it would be very difficult to generate a rally from that. So at the moment, the yen is holding near a 34 year low. It's 151 versus the dollar. And this is really quite difficult for the Ministry of Finance, they have started verbally intervening. The Finance Minister, Suzuki has mentioned the FX markets within the cabinet meeting, they are watching it with urgency. So, I think an intervention could be quite imminent. Now what they are saying as well is not necessarily the level, they don’t want to say, okay, 150 or 152. They don't want to trigger a level within the investors’ minds. However, they are talking about the speed of the move. And that's quite critical. And whether or not it's being driven by speculative sellers or fundamental drivers, that's going to be very important. So if you start to see a rapid sell off in the yen, and that could be hedge funds, and that's not something that they necessarily want to encourage or allow. So, you could see an intervention. The last time we saw an intervention was October 2022. And that's when it breached 150. You know, we're currently at 151. Could breach 152. It's very difficult from the Japan side, because really the currency is as I mentioned, responding to like carry differentials. The dollar’s strength is fairly broad based. The resilience and activity data has really been driving this yen dollar move as well. And you know, later on this week, we have data such as the non-farm payrolls. So I think all of these US data points are going to be driving the currency as well. It's not something that the BoJ can control and they've been very honest about that. That you know, I think over the medium term, the yen could start to respond to changes in the Fed and the BoJ policy, but this is not something that's going to help imminently. So, there’s very little that the BOJ can do and it's really down to the Minister of Finance to intervene. And also, it's you know, the timing, as we'll discuss later, the timing of the Fed cut cutting cycle and the scale of that is going to be really important for the currency as well. So unfortunately, it's not in the hands of the BoJ anyway.

Luke Bartholomew: So for sure, the Bank of Japan probably can't control where the currency goes. But I guess one lever that they might have is that they could push interest rates up a bit further from here. As you say, 10 basis points maybe doesn't move the dial very much, but a further series of hikes could start to close that rate differential. So, what's your outlook for the future path for Bank of Japan policy? And what do you think the key things are that policymakers will be looking at as they make those decisions?

Sree Kochugovindan: Yes, you're right. There was very little indication in the press conference about further hikes. Governor Ueda was very clear that policy would remain accommodative. But we do think there's room for maybe a bit more, not much more. So, we’re looking at the overnight call rate to settle at a midpoint of 25 basis points by the end of the year. The timing of that is very difficult to call. And I would actually still say that every meeting is live. I would say the April meeting is live. Now what are they looking at what is going to trigger this? Obviously, as we mentioned, wage growth is very, very important. There'll be further announcements from the Shunto in the coming weeks. That's going to be important. That's going to play a role. I think what’s also important to remember is that in April, we have the start of the new fiscal year. And that's when you can see a series of price hikes from different firms. They tend to happen around that beginning of the year. Now, the announcements so far have been a bit lacklustre. But if there is a bit of a pickup in price pass through, and also we could see some wage hikes at that time. That'll be quite an interesting indication for the BoJ. So that April and May inflation data is going to be very important. We also have a couple of other qualitative and quantitative indicators. So, the Sakura Regional Bank report that's out on April the 20th. As I mentioned, the BoJ meeting, we also have then the economic outlook and that will give us a steer of what they're thinking in terms of the main economic indicators, the inflation forecast, I mean, they aren't, they aren't so optimistic about inflation, they're hoping to reach target by the end of their forecast range, which was March 2026. So, let's see what they say in the next economic outlook. So that'll be out April 26. And I think those are the main indicators from here. But what we could see, I mentioned that 25 basis points, but they could see that corridor that zero to 0.1%, that could shift up by 10 bps, say in July, and another 10 bps by October. So the profile of this is quite fluid. And it will depend on various speeches, we're watching, Shunto and data. But we are looking at a very limited increase in rates ultimately. And that would be the overall conclusion here, it's going to be very difficult given the path of inflation. A lot of those drivers that we've seen over the past year that drove inflation to historic highs, even for Japan, they were very much global drivers, and they're starting to unwind. And it's very difficult against that backdrop, if you don't have domestically driven inflation, it's difficult to really hike much further than that. So a midpoint of 25 basis points is what we're looking for, really for this year.

Paul Diggle: Great. Well, James, let's turn to the US and the Federal Reserve then where there are also plenty of questions about the path of interest rates, albeit in the other direction and the outlook for inflation. So why don't we start by quickly recapping that Fed meeting in March, the key takeaways from the forecast changes from the dot plot?

James McCann: Absolutely. So the Fed meeting, you know they were obviously unchanged at that. And really, it was about understanding how their guidance might have changed - in particular, given the backdrop of very significant inflation surprises at the start of the year. So the sensitivity to those upside disappointments on inflation. And I think the profile of those changes was quite interesting and maybe told us something about the Fed’s reaction function at the moment. So certainly they mark to market what they expect on inflation. So, they pushed up their core PCE forecast to 2.6% at the end of this year. In terms of backdrop, core PCE is currently running at 2.8% year on year so that really implies a very slow and marginal further progress in lowering net annual run rate of core PCE inflation. So they mark that to market and implicitly expect really not that much in terms of further deceleration this year. They do think it will continue into 25 and into 26. But, you know, some signs, I suppose, of a sticky last mile of inflation, so to speak, coming through in their forecasts. Alongside this, they pushed up their growth forecasts, again, reacting to the strength of short-term data, particularly through the end of 2023 and persisting into 2024. So, you know, on the face of it, stronger inflation and stronger growth, but the headline, interest rate forecasts, so the median dot of FOMC members, their individual forecast for interest rates, still continues to pencil in three cuts by the end of this year. Now, within that distribution, there were some changes. So some of the individual member dots certainly moved higher. But it wasn't enough to shift that that three dots signal. And then moving away from the more mechanical forecast-based indications of where Fed policy might go in Chair Powell was surprisingly sanguine about the strength in short-term inflation. He thought of this as a bump along the disinflationary path, something that we should have been anticipating. Anyway, he expected that some of it was seasonally driven. He really talked down the signal from that short term bump in inflation, and expressed a lot of confidence that disinflation would proceed, albeit, again, at a bumpy and slow rate. And he was keen too to move the focus away from inflation. So he spoke about, you know, the risks on the other side of the Fed’s mandate. Certainly, this sense of the Fed doesn't want to be seen as too obsessed with getting that core inflation back to 2%. It's cognisant around the risks to the employment components and its mandate. So all in all, I think, a relatively dovish set of forecasts in terms of the profile of those growth inflation changes, but fewer changes to the expectations around cuts, and then certainly a dovish communication. So it was something that the market took well and pushed them to pricing in a little bit more, particularly after the meeting, in terms of Fed easing this year.

Paul Diggle: Why don't we indulge, James, at a bit of dot plot Kremlinology? Because although the median dot remained at an expectation of three rate cuts this year, the moves in the dots really made that a wafer-thin margin between three and two, and since that  FOMC, meeting, a number of FOMC members have kind of outed themselves in terms of, or seemingly, kind of said which dot they are on the dot plot. And some of that is pushed back in a slightly more hawkish direction. So do we think that there is a core of the committee around Powell set on three dots, sanguine on the inflation outlook? Or actually, is it a more complicated picture than that?

James McCann: My initial impression after the meeting was that the core of the committee given Powell’s, you know, relatively forthright comments around inflation, my sense was that the core of the committee was relatively unified around this. Well, we've had disappointments, but we're on the right path type of type of message. As you say, since then, we've had, you know, individuals come out and try and signal either explicitly or implicitly where they are on that dot plot. Regional Fed presidents have been particularly prominent there. And they do tend to be a little bit more flighty in terms of the dots either on the hawkish or dovish side. What's more surprising is to see an FOMC board member and a high profile one at that, Waller, come out. And I think signal that he's probably fewer than three cuts this year. He doesn't say it explicitly, but he guides in that direction. His speech is entitled ‘no rush to cut interest rates’, which is a very pointed title and is followed up by a number of more hawkish comments, talking about concerns about the short-term uplift in inflation, reassurance about the strong growth in the US economy and the relative risks around the Fed’s mandate of inflation and growth. And quite explicitly said the information received since the start of this year should cause members to revise some of their cuts away. So, some sense that there's fractures, even if we think of the Fed Board as being sort typically more unified and representing the core of the FOMC versus the regional Fed Presidents who can sometimes be more esoteric in their thinking. There's some sense that even among that Fed Board, there's fewer unified views. And that really puts the onus on the data. So, I think that makes it more important that we do see signs of a deceleration in inflation for those members who are more concerned to be brought along on a potential cut in the summer.

Luke Bartholomew: As you say, James, said the data is obviously the key context for this debate. And I suppose the market itself is having this debate about the data and recently or most recently at least it's got itself excited again about the possibility of a so called ‘no landing’ - that is growth and inflation remaining strong this year. So, do you just want to give us a sense of what the most recent data has been that sort of pushed the market in that direction and where it's left your thinking around the relative risks of no landing or any other kinds of landing?

James McCann: Yeah, it feels it’s three years on, and we're talking about landing this plane aren’t we. But the data I think that are maybe most concerning the market are perhaps on the activity side. Certainly we've already internalised what's happened on inflation, we got that big spike in January, there was a strong number in February too, albeit with slightly different drivers. I think the market is looking now at some of the activity data and may be seeing signs, if not a reacceleration and growth, just a continuation of relatively robust growth. You know, things that I've noticed that maybe are pushing in that direction a little bit more firmly, are things like the breakdown of the personal consumption expenditure report. You know, we've seen very clearly in the retail sales data, which are more timely that consumers are spending less on goods. And I think that had been taken as an indication that that core engine of US growth was moving down a gear. We only get the services data contained in that personal consumption expenditure report a little bit later. But that showed that maybe it's more of a redistribution. So as consumers are spending less on goods, they've been spending a bit more on services. So the aggregate slowdown in overall consumer spending, for the time being looks, looks a bit less pronounced. And then if we move away from that consumer engine, we have seen, while aggregate US growth has been very resilient, we have seen the more classically, interest rate sensitive sectors like residential housing, construction, industrial and manufacturing production cycles, they have certainly been weaker, but there are signs of stabilisation there. And that's certainly been the case in the resi investment sector over the second half of last year. And you know, as you mentioned early this year, things like the manufacturing ISM moving back above that important 50-point mark, which signals expansion versus contraction. That could be telling us, along with other data, that that interest rate sensitive sector is starting to pick up a bit of momentum again, maybe as markets look ahead to easier interest rates and financial conditions start to ease. So I think the markets have become a bit more concerned that that strong growth is exacerbating some of that early year inflation pressure and could continue to do so. And that could torpedo the Fed’s plans to ease.

Luke Bartholomew: So shifting away from these cyclical questions, another big debate in the market, and amongst the Fed at the moment is around where R*, the equilibrium or neutral rate might sit. And I guess the dog that didn't bark in the last FOMC meeting was that there was some expectation, in fact, it felt like the market was almost bracing itself, for the so-called long dot in the Fed’s dot plot, which the market often equates to being the Fed’s best estimate of where R* sits. That was expected to rise - and it did rise a touch to 2.6%-but I think perhaps less than some had expected. And I think it's probably fair to say that, you know, in the eyes of many market participants, that's quite low, although not necessarily our view, I think we tend to think that normal R* is probably around that kind of level. But what is your take on the nature of the debate both in the Fed itself and in the markets about where long run neutral rates sit?

James McCann: Yeah, that upward revision was remarkably underwhelming, especially given some of the build-up. And for context, the Fed’s view on long run rates, R*, has remained unerringly stable over recent years. And in part, I think this reflects a Powell-led mantra to sort of be less focused on some of these equilibrium variables or less sensitive around, you know, short term changes to them, allowing the data in the economy to help push you in that direction a little bit more. You know, I think it's right that the market is potentially challenging the Fed on this. So if we look at where markets expect interest rates  to level off  in a few years, then you're talking at least 100 basis points if not, if not more, around the Fed’s estimate of neutral and perhaps, you know, that's not an enormous surprise, because you could take, you know, the experience of what we've been through over recent years as evidence of a of a higher R*. The economy's ability to live with higher rates - and not just live with them grow relatively robustly. The signs of a stronger supply backdrop, which could tell you that potential growth is stronger - that will be something that could raise R*. So, it’s perhaps not hugely surprising to see. The market challenged the Fed a little bit on that dynamic. I think the Fed’s instinct is to be slow moving about this to allow the data in the real economy to tell it where R* is going and how sustainable and the increase in our star may be, as you said, our fundamental view is that a number of the structural forces which have been pushing down on R* in the decade before the financial crisis, and indeed before, before that decade, for a much longer period, they remain in place both domestically and globally. So, our instinct is that R* does remain low. But if the Fed were to see growth rates hold up relatively robustly, the economy live with high interest rates, you know, around that ‘no landing’ or even, you know, more favourable supply style shocks, and that could tell it that R* is rising, and, you know, their tentative adjustment upward in R* or the long term rate that they're expecting in the economy, in this summary of economic projections that could be replicated over many, many quarters. It's not our base case, but it's certainly something you know, we're watching very closely.

Luke Bartholomew: And then so just to wrap things up, maybe it's worth just as a quick reminder, James, as to sort of what's at stake in this R* debate - in that it's a question that we come back to often on the podcast, but perhaps it sounds a little bit esoteric, to be thinking about these equilibrium policy rates. So why is it so important, both from a cyclical and structural perspective to you know, try and figure out where this number lies?

James McCann: Yeah, I mean, R* sounds incredibly abstract doesn’t it. I mean, the other names for R* ar  ‘equilibrium rates’ or ‘long term rates, you know, these aren't things that capture the imagination, but they're, they're really important. And there's lots of reasons for that. I can outline, maybe three now. One is that, you know, R*can be thought of as an anchor around where interest rates settle or move or oscillate. And there's so much focus at the moment around this hiking cycle and a potential easing cycle. And certainly, that's very important. But when we move away from that classic sort of business cycle driven movement in interest rates, the anchor point at which that oscillation will occur is determined by where R* settles, so it's really important for shaping and informing what the sort of long term trend in interest rates looks like in the economy. You know, is it the case that following this fire when we finally land this plane, interest rates are settled at 4%, or 3%, or 2%. That's really important from a market and from a macro perspective. The second reason is that R* tells us a lot around the fundamentals in the economy. It tells us a lot, potentially around what the potential growth outlook looks like. That plays an important role in shaping R*. So you know if markets are baking in an R* of  a certain level, then that will come I suppose in the associated view on what long term growth and inflation dynamics look like, what the earnings profile associated with that is. So, it's macro economically important and helps shape the investment environment in that direction, too. And then finally, one of the issues that the Fed had with the drop in R*in the 2010s was it was really hard, then to get policy loose enough. So to get policy supportive, you need to get actual interest rates a good way below that, that equilibrium rate, R*, and when R* shrinks your room to play with, really, really falls until you hit that lower boundary - so around 0%. Central banks as we hear from Japan have obviously got a little bit below there, but but not a long way below there. So, it's possible that if R* has risen, then that means that central banks will find themselves with more policy ammunition when and if the next downturn comes, and there'll be less liable to get stuck at the lower bound in the way that they did in the 2010s. And, again, that has implications for how markets think about inflation, how markets think about the stability of growth and business cycles. You know, we went through an era of the world of low numbers in which interest rates inflation and growth was relatively subdued. R* is obviously a more sustainable way out of that world.

Luke Bartholomew: All right, well, I think that is all we have time for this week. We will no doubt have much more to say about R* in the future. But for now, as ever, please do like and subscribe, wherever it is that you get your podcasts and all that remains is for me to thank James and Sree for joining us today and to thank you all for listening. So thanks very much and speak again soon.

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