Central Banks Near Peak Rates, but Inflation Challenge Persists, 2023.
Central banks in major economies are widely perceived to have either reached or be on the verge of reaching their peak interest rates. Last week, the European Central Bank (ECB) indicated that its Governing Council believes interest rates may have peaked.
Following extensive deliberations over updated forecasts for inflation and economic growth, the ECB raised its key rate to a record high of 4%. While the ECB’s statement didn’t rule out future rate hikes entirely, it acknowledged that if sustained for a sufficient duration, current rates would significantly contribute to bringing inflation back to its target.
However, the short-term inflation outlook remains challenging and is expected to impact households. The ECB’s projections now anticipate euro area inflation averaging 5.6% this year, up from the previous estimate of 5.4%, and 3.2% next year, compared to the previous forecast of 3%.
One of the key metrics to watch is the 2025 forecast, which has been adjusted downward from 2.2% to 2.1%. Economists, including Holger Schmieding from Berenberg, are now focused on how long interest rates will remain at their current level. Deutsche Bank analysts predict no rate cuts before September 2024, suggesting a 12-month pause at 4%.
Nevertheless, challenges persist, including the potential for significantly higher oil prices.
Crude oil futures recently reached a 10-month high, which could impact the cost of goods and inflation expectations in Europe and the U.S.
Raphael Thuin, head of capital markets strategies at Tikehau Capital, warns that despite consensus around the end of the ECB’s hiking cycle, there’s an alternative and less optimistic scenario to consider: inflation may prove to be stronger and more persistent than anticipated, potentially becoming structural.
Thuin notes that recent disinflationary factors, such as goods and commodity prices, are losing momentum. Without a more convincing downward trend in prices, the ECB could perceive its battle against inflation as unfinished, raising the possibility of further rate hikes.
Ultimately, the direction of macroeconomic data in the coming weeks will play a decisive role in shaping the central banks’ policies and determining whether the battle against inflation is truly over or if more rate hikes are on the horizon.
The ECB’s recent rate hike represents a significant step in combatting rising inflation. Still, the future remains uncertain, and central banks must remain vigilant in their approach to monetary policy.
Federal Reserve Chair Jerome Powell indicated last month that additional interest rate hikes were being considered, citing the central bank’s deep concern about the potential for inflation to accelerate if financial conditions ease. In its June forecast, the Federal Reserve did not anticipate inflation reaching 2.1% until 2025.
However, monthly data continues to reveal ongoing price pressures, with the consumer price index experiencing its most rapid monthly increase of the year in August, primarily driven by rising energy prices. Consumer prices rose by 3.7% yearly, while core inflation increased by 0.3% every month and 4.3% annually. Producer price inflation also saw its largest monthly gain since June 2022.
Despite these inflationary pressures, the financial markets are nearly certain that the U.S. Federal Reserve will maintain interest rates at their current levels in September. There is division among market participants regarding the likelihood of another rate hike this year.
According to a Reuters poll of economists, 20% expect at least one more rate hike. Some economists believe that the Fed will maintain a hawkish stance due to the relatively strong economic data and persistent inflation. They suggest that the Federal Open Market Committee (FOMC) include a final rate hike in its updated dot plot, even though they don’t anticipate it will ultimately follow through.
Market expectations for the Federal Reserve include potential rate cuts next year, although some argue that such expectations may be premature. The Reuters poll mentioned earlier found that 28 economists expect the first rate cut to occur in the year’s first quarter, while 33 anticipate it in the second quarter.
Turning to the Bank of England, the prevailing outlook is for one more rate hike in September. The bank is carefully considering inflation, which has risen to 6.8%, along with signs of strain on the economy and renewed discussions of a possible “mild recession.”
In its August report, the Monetary Policy Committee (MPC) predicted that inflation would reach 5% by the end of the year, decrease by half by the end of the following year, and return to the 2% target by early 2025.
However, some experts suggest that the Bank of England may not be in a precise position where rate hikes are unequivocally necessary. Marcus Brookes, Chief Investment Officer at Quilter Investors, pointed to weak gross domestic product (GDP) data for July as a factor.
BNP Paribas analysts anticipate a final “dovish hike” in September due to wage growth, inflation pressures, and softer activity indicators.
While wage growth remained steady at a record high level of 7.8% from May to July, there have also been indications of a cooling job market, with a 0.5 percentage point increase in unemployment during the same period.
Another area of concern is the mortgage market, where payments in arrears surged to a seven-year high in the three months to June.
James Smith, a developed markets economist at ING, observed that both expected price growth and expected wage growth had declined, and fewer firms reported difficulties in finding staff.
He suggested that a rate hike in November was possible, but based on recent Bank of England comments and the direction of data, a pause at that meeting seemed more likely.
In summary, central banks like the Federal Reserve and the Bank of England are carefully navigating the challenges posed by inflation and economic indicators. While inflationary pressures persist, the timing and magnitude of future rate hikes remain subjects of debate, reflecting the complex economic landscape.
