Asset allocation: when will enacted policy tightening begin to bite?
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Asset allocation: when will enacted policy tightening begin to bite?

An ongoing focus of central banks is bringing inflation levels sustainably back towards target, but how should you interpret the lag time between policy implementation and economic impact?

  • Key developed market central banks remain focused on bringing inflation levels sustainably back towards targets
  • Persistent labour markets and core measures have forced policymakers to tighten policy more than previously anticipated
  • However, policy changes impact economies with lags, and interpretation of the length of these is key to seeing whether enough has already been done

As the world emerged from Covid lockdowns over 2021 and into 2022, the focus of consumer demand expanded from goods towards more labour-intensive services areas. Combined with a decrease in the labour participation rate, this spurred a tightening in labour markets and an associated pick-up in wage growth.

Central banks cannot meaningfully impact – and should look through – short-term inflation fluctuations driven by supply-side issues, à la the initial Covid goods-driven inflation and the now-mocked “transitory” phrasing. However, a spread of increased pricing into elevated core inflation and wage growth provided a link to self-sustaining above-target inflation, which is something central banks are mandated to target through policy change. As such, beginning with the Bank of England (BoE) in December 2021, key developed market central banks embarked on a rapid programme of policy tightening aimed at rebalancing supply and demand across economies to equilibria consistent inflation targets (Figure 1).

Figure 1: US inflation versus policy rate
Figure 1 US inflation veresus policy rate

Source: Bloomberg, 30 June 2023

From here the key area of debate is whether central banks have already implemented enough tightening to bring demand sufficiently lower. The extremes in this debate are: “(more than) enough has been done and all that is required is for more time to pass and for the full effects to be felt”; and “the effects have already fully materialised, and more tightening is required to bring core inflation to target”.

This discussion centres around the duration of the lag from any incremental tightening to the associated decrease in demand. We have tested the empirical relationship between changes in central bank policy rates and changes in GDP growth across the US, UK and eurozone. The lag from policy change initiation to economic impact is found to be 11 months in the US (Figure 2), eight months in the UK, and nine months in the eurozone. This suggests that the economic impact of the rate rises began to be felt in Q1 2023 for the US, and in Q3 2022 and Q2 2023 for the UK and eurozone, respectively. However, importantly this work also suggests that the peak impact from implemented rate hikes won’t come until around Q4 2023/Q1 2024.

Figure 2: lagged change in Fed Policy Rate versus change in US GDP growth
Figure 2 lagged change in Fed Policy Rate versus change in US GDP growth

Source: Bloomberg, 30 June 2023

The work also tested for historic lags from policy tightening to labour market impact. As one might expect, the lags here are slightly longer as firms tend to react to a worse economic environment by cutting staff. Relationships here point to peak labour market impact occurring in Q1/Q2 2024 in the US and UK, and Q4 2024 in the eurozone.

Unsurprisingly, these relationships are not consistent over time given that at any one point any number of other factors impact GDP growth and labour markets, in addition to policy rate changes. For example, in the UK mortgages are logically a key transmission mechanism from higher policy rates to reduced economic activity. However, trends in the structure of this market point to a change in the pass-through rate of monetary policy tightening. The proportion of UK mortgages agreed with floating rates in 2012 was more than 70%; in Q1 this year it was 12.5%. As such, any policy tightening from the BoE that would have immediately reduced disposable income for a higher proportion of households in 2012 now does so to a much smaller proportion of households. While the full effect of higher rates will be felt across all mortgage-bound households eventually, it will take years to feed through – around half of all mortgages taken out in 2021 were done so on a five-year fixed term. Indeed, assuming rates remain where they were at the end of May, the average outstanding mortgage rate will likely only reach 4% in Q3 2024 (Figure 3). As a result, in the UK the model-implied peak GDP impact of rate hikes of October 2023 is likely to come later than history would suggest.

Figure 3: new versus existing UK mortgage rates
Figure 3 new versus existing UK mortgage rates

Source: ONS and Bank of England, 31 March 2023

While precise timing around when the full effect of policy tightening is felt remains uncertain, we are confident that from here economic activity will continue to feel the drag of already-implemented policy tightening to a greater extent. In-line with this, we continue to structure our Multi-asset portfolios with increased government bond duration allocations, and slightly reduced equity allocations.

17 July 2023
Ben Rodriguez
Ben Rodriguez
Fund Manager, Multi-asset
Matthew Rees
Matt Rees
Fund Manager, Managed Funds
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Asset allocation: when will enacted policy tightening begin to bite?

Important Information

For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients). This is a marketing communication. The mention of stocks is not a recommendation to deal.

This document is intended for informational purposes only and should not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services. Investing involves risk including the risk of loss of principal. Your capital is at risk. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. The securities included herein are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This document and its contents have not been reviewed by any regulatory authority.

In Australia: Issued by Threadneedle Investments Singapore (Pte.) Limited [“TIS”], ARBN 600 027 414. TIS is exempt from the requirement to hold an Australian financial services licence under the Corporations Act and relies on Class Order 03/1102 in marketing and providing financial services to Australian wholesale clients as defined in Section 761G of the Corporations Act 2001. TIS is regulated in Singapore (Registration number: 201101559W) by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289), which differ from Australian laws.

In Singapore: Issued by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07, Winsland House 1, Singapore 239519, which is regulated in Singapore by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289). Registration number: 201101559W. This advertisement has not been reviewed by the Monetary Authority of Singapore.

In Hong Kong: Issued by Threadneedle Portfolio Services Hong Kong Limited 天利投資管理香港有限公司. Unit 3004, Two Exchange Square, 8 Connaught Place, Hong Kong, which is licensed by the Securities and Futures Commission (“SFC”) to conduct Type 1 regulated activities (CE:AQA779). Registered in Hong Kong under the Companies Ordinance (Chapter 622), No. 1173058.

In Japan: Issued by Columbia Threadneedle Investments Japan Co., Ltd. Financial Instruments Business Operator, The Director-General of Kanto Local Finance Bureau (FIBO) No.3281, and a member of Japan Investment Advisers Association.

In the UK: Issued by Threadneedle Asset Management Limited. Registered in England and Wales, Registered No. 573204, Cannon Place, 78 Cannon Street, London EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority.

In the EEA: Issued by Threadneedle Management Luxembourg S.A. Registered with the Registre de Commerce et des Societes (Luxembourg), Registered No. B 110242, 44, rue de la Vallée, L-2661 Luxembourg, Grand Duchy of Luxembourg.

In Switzerland: Issued by Threadneedle Portfolio Services AG, Registered address: Claridenstrasse 41, 8002 Zurich, Switzerland.

In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). For Distributors: This document is intended to provide distributors’ with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.

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Important Information

For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients). This is a marketing communication. The mention of stocks is not a recommendation to deal.

This document is intended for informational purposes only and should not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services. Investing involves risk including the risk of loss of principal. Your capital is at risk. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. The securities included herein are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This document and its contents have not been reviewed by any regulatory authority.

In Australia: Issued by Threadneedle Investments Singapore (Pte.) Limited [“TIS”], ARBN 600 027 414. TIS is exempt from the requirement to hold an Australian financial services licence under the Corporations Act and relies on Class Order 03/1102 in marketing and providing financial services to Australian wholesale clients as defined in Section 761G of the Corporations Act 2001. TIS is regulated in Singapore (Registration number: 201101559W) by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289), which differ from Australian laws.

In Singapore: Issued by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07, Winsland House 1, Singapore 239519, which is regulated in Singapore by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289). Registration number: 201101559W. This advertisement has not been reviewed by the Monetary Authority of Singapore.

In Hong Kong: Issued by Threadneedle Portfolio Services Hong Kong Limited 天利投資管理香港有限公司. Unit 3004, Two Exchange Square, 8 Connaught Place, Hong Kong, which is licensed by the Securities and Futures Commission (“SFC”) to conduct Type 1 regulated activities (CE:AQA779). Registered in Hong Kong under the Companies Ordinance (Chapter 622), No. 1173058.

In Japan: Issued by Columbia Threadneedle Investments Japan Co., Ltd. Financial Instruments Business Operator, The Director-General of Kanto Local Finance Bureau (FIBO) No.3281, and a member of Japan Investment Advisers Association.

In the UK: Issued by Threadneedle Asset Management Limited. Registered in England and Wales, Registered No. 573204, Cannon Place, 78 Cannon Street, London EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority.

In the EEA: Issued by Threadneedle Management Luxembourg S.A. Registered with the Registre de Commerce et des Societes (Luxembourg), Registered No. B 110242, 44, rue de la Vallée, L-2661 Luxembourg, Grand Duchy of Luxembourg.

In Switzerland: Issued by Threadneedle Portfolio Services AG, Registered address: Claridenstrasse 41, 8002 Zurich, Switzerland.

In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). For Distributors: This document is intended to provide distributors’ with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.

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