Major central banks were soon to suspend rate hikes. Now it’s not so clear

The market has long priced in interest rate cuts from major central banks towards the end of 2023, but sticky underlying inflation, tight labor markets and a surprisingly resilient global economy are leading some economists to reassess.

The stronger-than-expected US jobs numbers and gross domestic product data highlighted a key risk for the Federal Reserve that could lift the foot of the monetary brake. Economic resilience and continued tightness in the labor market could put upward pressure on wages and inflation, which risks becoming entrenched.

The headline consumer price index in the United States has cooled considerably since its peak above 9% in June 2022, falling to just 4.9% in April, but remains well above the Fed’s 2% target. Importantly, the core CPI, which excludes volatile food and energy prices, rose 5.5% annually in April.

As the Fed implemented its 10th interest rate hike since March 2022 earlier this month, taking the federal funds rate to a range of 5% to 5.25%, Chairman Jerome Powell left hearing that a pause in the bullish cycle is likely at the June FOMC meeting. .

However, minutes from the last meeting showed that some members still see the need for further hikes, while others anticipate that a slowdown in growth will remove the need for further tightening.

Fed officials, including St. Louis Fed President James Bullard and Minneapolis Fed President Neel Kashkari, have indicated in recent weeks that persistent core inflation could keep monetary policy going. stricter for longer and further increases could occur later in the year.

The personal consumption expenditure price index, a favorite Fed indicator, rose 4.7% year-on-year in April, new data showed on Friday, indicating further stubbornness and triggering new rate bets. longer-term higher interest rates.

Several economists have told CNBC over the past two weeks that the U.S. central bank may be forced to tighten monetary policy more aggressively in order to break through stubborn underlying momentum.

According to CME Group’s FedWatch tool, the market is currently placing a nearly 35% probability on the target rate ending the year in the 5% to 5.25% range, while the most likely range by November 2024 is 3.75% to 4%.

Patrick Armstrong, chief investment officer at Plurimi Group, told CNBC last week that there is a double risk to the current market positioning.

“If Powell cuts he’s probably cutting a lot more than market prices, but I think there’s a better than 50% chance he’ll still be sitting on his hands, we’re coming to the end of the year,” said Armstrong.

“Because the services PMI is incredibly strong, the employment backdrop incredibly strong, consumer spending very strong, these are not the kinds of things the Fed really needs to inject cash into. unless there is a debt crisis.”

European slowdown

The European Central Bank faces a similar dilemma, having slowed the pace of its hikes from 50 basis points to 25 basis points at its May meeting. The bank’s benchmark rate is at 3.25%, a level not seen since November 2008.

Headline inflation in the euro zone rose in April to 7% year-on-year, although underlying price growth recorded a surprise slowdown, prompting further debate over the pace of rate hikes the ECB should enact as she seeks to bring inflation back to Earth.

The eurozone economy grew 0.1% in the first quarter, below market expectations, but Bundesbank President Joachim Nagel said last week that several more rate hikes will be needed even if it pushes the bloc’s economy into recession.

“We are not in an easy phase at all, because inflation is sticky and it is not developing as we all hoped, so it is quite important, as Joachim Nagel said today. today, that the ECB remains open to further rate hikes for as long as it needs until the filing is complete,” the former Bundesbank board member told CNBC. Andreas Dombret, last week.

“Of course it will also have negative implications and negative effects on the economy, but I strongly believe that if you let inflation (unanchor), if you let inflation go, these negative effects will be even greater. , so it is very important for the credibility of the ECB that the ECB stays the course.”

The Bank of England

The UK faces a much tougher inflation challenge than the US and the Eurozone, and the UK consumer price inflation rate fell less than expected in April.

The annual consumer price index rose from 10.1% in March to 8.7% in April, well above consensus estimates and the Bank of England forecast of 8.4%. Meanwhile, core inflation jumped to 6.8% from 6.2% in March, which will further concern the Bank’s Monetary Policy Committee.

As inflation continues to prove more rigid than the government and central bank had hoped, now almost double the comparable rate in the United States and considerably higher than in Europe, traders have raised bets on the fact that interest rates will have to be raised further in order to curb the rise in prices. .

“Supply shocks, still-unanchored inflation expectations, fewer promotional discounts and some potential margin buildup are likely preventing prices from normalizing as quickly as traditional models would imply,” explained economist Sanjay Raja. Chief UK Officer at Deutsche Bank.

“We now expect a slower descent towards the target, and with price and wage inflation now expected to remain stronger than expected, we are raising our terminal rate forecast to 5.25%. We believe that risk management considerations will force the MPC to push rates higher and further than previously expected.”

Deutsche Bank now sees monetary policy moving “firmly” into a “higher for longer” era, Raja added.

The market is now pricing a 92% chance of another 25 basis point rate hike from the Bank of England at its June meeting to take the main bank rate to 4.75%, according to Refinitiv data. Friday afternoon.

But despite expectations of an even longer rate hike, many economists still see a complete reversal of course before the end of this year.

Berenberg had previously forecast three cuts by the end of 2023, but cut that figure to one in response to inflation last week.

The German bank maintained its end-2024 call for an unchanged 3% rate, forecasting six 25 basis point cuts over the next year, but also put a 30% probability on another 25 basis point hike. basis in August to take the discount rate to 5%.

“Policy shifts operate with uncertain effects and varying lags. Due to the shift from variable rate mortgages to fixed products over the past decade, the transmission of monetary policy to consumption via the housing market is taking longer than in the past,” said Berenberg senior economist Kallum Pickering.

“This highlights the risk that, if the BoE overreacts to short-term inflation surprises, it could pave the way for a sharp fall in inflation once the full effects of its past policy decisions wear off. will be manifested.”