The peak drag on consumption caused by European Central Bank (ECB) monetary policy will likely occur in the first two quarters of 2024, according to Vanguard research.
It will be an important development in a region where consumption accounts for 50%–55% of economic activity. Our research model assumes that the ECB holds its current, 4% deposit facility rate steady through the end of our forecast horizon in September 2026.
Notes: The simulation estimates the impact of the European Central Bank’s current tightening cycle to euro area consumption and assumes the deposit facility rate stays at the current 4% level for the entire forecast horizon. It uses a proprietary error-correction model that predicts euro area consumption using a combination of short- and long-term drivers, including disposable income, unemployment rate, household wealth, and short-term interest rates.
Sources: Vanguard calculations through September 30, 2023, using data from Bloomberg.
A lowering of the ECB’s deposit facility rate would ease the drag of policy on consumption, but we don’t expect the central bank to cut interest rates until at least the second half of 2024.
“The ECB will want to maintain the progress it has made in the inflation fight, and that will likely require holding interest rates at their current high level well into 2024,” said Shaan Raithatha, a Vanguard senior economist. “We may not see a ‘painless disinflation’ where growth and employment are unaffected by higher rates.”
The views below are those of the global economics and markets team of Vanguard Investment Strategy Group as of October 19, 2023.
The Reserve Bank of Australia (RBA) left its cash rate unchanged at 4.1% for a fourth consecutive policy meeting early this month. The bank is balancing concerns that inflation remains too high, especially in the services sector, with growing economic uncertainty.
The first reading of third-quarter gross domestic product (GDP), due to be released October 26, may reflect continued economic resilience. Vanguard’s proprietary economic tracking model suggests that the quarter’s GDP growth could be roughly twice our original expectation of 1.5%, annual ised. Consumption continues to drive gains; resilience has broadened and remains diversified across sectors.
Last month, the People’s Bank of China (PBOC) cut the reserve requirement ratio by 25 basis points (0.25 percentage point) for all financial institutions with ratios above 5%. Vanguard sees the move as intended to boost sentiment and to meet a demand for liquidity amid an acceleration in local government bond issuance.
The European Central Bank (ECB) raised its deposit facility rate by 25 basis points (0.25 percentage point) in September, to a record high of 4%. The monetary policy statement appeared to confirm our view that the bank’s rate-hiking cycle, which began in July 2022, is over. We expect the bank to maintain its 4% rate at least until the second half of 2024.
A better-than-expected August inflation report allowed the Bank of England (BOE) to hold the bank rate at 5.25% last month. The pause, like that of the Federal Reserve, reflects the bank’s progress in its inflation fight and its desire not to restrict growth more than necessary, as discussed in Winding down the monetary tightening cycle, a commentary with Vanguard senior economists Shaan Raithatha and Josh Hirt.
Slowing inflation and slower growth have allowed emerging market (EM) central banks to pause rate hikes; some have even started cut rates. Chile, Poland, and Brazil were among those that cut rates in recent months.
Real gross domestic product (GDP) contracted in the second quarter (–0.2% quarter-over-quarter, annualised) and was revised downward for the first quarter (to 2.6%). Consumer spending retrenched. Housing activity also weighed on GDP growth for the fifth straight quarter. However, leading indicators for economic activity, while negative, have improved, suggesting a smaller third-quarter contraction.
Our 10-year annualised nominal return and volatility forecasts are shown below. They are based on the June 30, 2023, running of the Vanguard Capital Markets Model® (VCMM). Equity returns reflect a range of 2 percentage points around the 50th percentile of the distribution of probable outcomes. Fixed income returns reflect a 1-point range around the 50th percentile. More extreme returns are possible.
Australian equities: 4.2%–6.2% (21.7% median volatility)
Global ex-Australia equities (unhedged): 4.8%–6.8% (19.4%)
Australian aggregate bonds: 3.8%–4.8% (5.5%)
Global bonds ex-Australia (hedged): 4.0%–5.0% (4.7%)
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The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
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