Central banks hike rates again - but for how much longer?

The US Federal Reserve (Fed), European Central Bank (ECB) and Bank of England (BoE) have all raised their respective policy interest rates in the past 24 hours as part of ongoing tightening of monetary policy to curb inflation.

Our economists share their views on the various policy changes.

Fed takes smaller step as it reaches the summit

George Brown, Economist, said:

The Federal Reserve (Fed) slowed the pace of tightening in February 2023, but signalled that it plans to raise rates further in the months ahead. It raised rates by 25 basis points (bps), lifting the upper bound of the target range to 4.75%. This marked a moderation from the 50bps increase at the last meeting and the 75bps hike before that.

Still, the committee said that it planned to further tighten policy. Chair Jerome Powell sought to drive this message home in his press conference, insisting that the Fed has a “long way to go” before it could declare victory against inflation.

In the most recent ‘dot plot’ from December 2022, US policymakers expected the Fed funds rate would rise slightly above 5% in 2023. After the decision made on 1 February 2023, this would entail an additional 50bps of tightening over the coming months.

Evidently, the Fed’s judgement that further tightening is appropriate presents clear risks to our view that rates have now peaked. However, we see at least three reasons to think this will have been the last hike:

1. Economic activity is beginning to soften as rate rises have gained traction. And forward-looking measures such as the Conference Board’s leading indicator are flashing red.
2. The labour market is showing tentative signs of turning. Demand for workers appears to be cooling, while layoffs initially seen in the tech sector are becoming more widespread.
3. Inflation has convincingly moderated and should continue to do so. Stripping out the shelter category, which tends to be sticky, the core consumer price index (CPI) has been falling for three consecutive months.

It may be a view that the Fed is also coming to. While chair Powell stressed that the Fed would be “cautious about declaring victory” over inflation, there were dovish undertones to his press conference, including an acknowledgement that a “disinflationary process” was underway.

He also struck an upbeat tone on the economy, outlining that he could see a path to lower inflation without a “really significant economic decline or a significant increase in unemployment”. While not impossible, it is a scenario we still place a low probability on. 

It is a herculean task to fine tune policy tightening to the extent that you are able to engineer a so-called soft landing over a more severe downturn, particularly given the long and variable lags associated with such a blunt instrument as policy rates.

For that reason, we maintain our view that the US economy will deteriorate further and fall into recession in 2023. Our expectation is that this will see the Fed pivot to cuts later in 2023 as it shifts its focus to supporting growth, which is now fully priced into market.

Central banks eye exit from hiking cycle

Azad Zangana, Senior European Economist and Strategist, said:

Both the European Central Bank (ECB) and Bank of England (BoE) raised their key interest rates by half a percentage point, in the continued effort to lower inflation back to their respective 2% targets. Both increases were in-line with both consensus expectations and market pricing.

The fall in the price of natural gas in Europe featured in both statements, as this has been a large contributor towards higher inflation rates in 2022. The significant falls in prices since the end of 2022 was noted as a very helpful factor in lowering inflation rates later in 2023.

Headline CPI has generally fallen back from recent peaks, in line with official forecasts. The respective economies have both seen higher growth than expected, although they note that activity is expected to weaken further in the coming months. This is largely due to the rise in the cost of living along with higher interest rates, the latter of which has yet to be fully felt by households.

Labour market conditions remain tight, as unemployment rates remain low. Although the growth momentum in hiring has eased back considerably, both the ECB and BoE staff expect wage inflation to remain firm in the near-term, responding to higher inflation rates. But given easing demand for staffing, the risks of a wage-inflation spiral are easing.

Unusually, the ECB decided to give strong guidance that the governing council intends to raise interest rates again in March 2023 by another 50bps. The council has, in the past, tried to not pre-announce policy changes, but on this occasion, it felt that current indicators would not change the path in the near-term. The ECB has stated that from March 2023 it will “…evaluate the subsequent path of its monetary policy” – potentially creating an opportunity to pause rate rises.

Although ECB president Christine Lagarde said at the latest press conference that there was no commitment made from March 2023 onwards, our expectation, along with that in the market, is that interest rates would be kept on hold from that point on. This was supported by Lagarde’s comment that the risks to inflation have now become more “balanced”.

The ECB also announced a small amount of quantitative tightening – its first attempt at reversing its liquidity supports. It will allow up to €15 billion to mature in March, April and June 2023. This is very small when compared to the size of the ECB’s balance sheet, but nevertheless, it is a significant first step, to test the waters, and how Europe’s bond markets will react. If successful, expect more to follow.

For the BoE, there was no such pre-announcement for the future path from the monetary policy committee (MPC). Although the risk of persistently higher inflation in the UK remains extremely high, the central forecast has been nudged lower, partly due to lower energy inflation. Moreover, the BoE’s CPI inflation forecast shows that if interest rates rose in line with market expectations, inflation would undershoot the BoE’s target from 2024 – indirectly signalling that the profile is too high.  

The BoE’s meeting minutes stated that the latest 50bps rise “…would address the risk that domestic wage and price pressures remained elevated even as external cost pressures waned.” In addition, “The MPC would continue to monitor closely indications of persistent inflationary pressures, including the tightness of labour market conditions and the behaviour of wage growth and services inflation. If there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required.” This suggests that the UK interest rates may now be at their peak for this cycle.

While we believe that UK inflation will be stickier than the BoE forecasts, we do not believe that this would stop the dovish MPC from halting rate hikes.