- The Fed slows the pace of US rate hikes while the ECB pledges another 50bps raise next month
- The Bank of England raises interest rates by 50bps but signals that the peak may be close
Central banks delivered another trio of hikes this week, with the suggestion of more to come.
The Bank of England increased the base rate by 50bps, taking interest rates to 4 per cent – the highest level in almost 15 years. The Federal Reserve delivered a smaller 25bps hike, taking the Federal Funds target to 4.5-4.75 per cent, while the European Central Bank’s (ECB) more hawkish 50bps move increased the main deposit rate to 2.5 per cent.
But the tones of the meetings were very different.
After signalling for months that higher interest rates may be needed to bring inflation back down to target, the BoE suggested that the peak in interest rates could be close. The committee has relaxed its language around future rises, dropping a suggestion that it would respond “forcefully” in the future to inflation, and adding that further rate hikes would “depend on evidence of more persistent” inflationary pressures. Energy prices have come down in recent weeks, taking some of the momentum from across-the-board cost increases for consumers and businesses.
Despite slowing the pace of hikes, the Fed tempered hopes of a major policy shift, stating that “ongoing increases” in interest rates would still be required to return inflation to the 2 per cent target. Markets were nevertheless encouraged by more dovish comments made by chair Jerome Powell in a press conference following the announcement.
The ECB commentary was more hawkish, with the central bank pledging to raise rates by another 50 basis points in the March meeting in light of “underlying inflation pressures”. The ECB also gave more details on the operation of its quantitative tightening (QT) programme, due to start next month. The Bank plans to reduce its bond holdings by €15bn (£13bn) a month between March and June, with the subsequent pace of portfolio reduction to be determined over time.
Economic backdrop
All three central banks are facing the unsavoury combination of high inflation, stagnant growth and uncertain policy time lags. The Bank of England is facing the most difficult backdrop of all: CPI inflation remains elevated at 10.5 per cent, but higher interest rates could hammer an already flagging economy. Governor Andrew Bailey and Co now expect GDP to fall throughout 2023 and the first quarter of next year.
The latest monetary policy committee meeting comes in the wake of gloomy IMF forecasts suggesting that the UK will be the only advanced economy to enter recession this year. At the same time, the US economy will grow 1.4 per cent this year, while the euro area will manage 0.7 per cent, as per IMF forecasts. Inflation remains elevated in both economies, at 6.5 per cent in the US and 8.5 per cent in the EU.
Central banks must walk a difficult tightrope: stopping rate hikes too soon could see inflation surge back, but continued hikes raise the risk of ‘over-tightening’.
Suren Thiru, economics director at the Institute of Chartered Accountants in England and Wales, said the combination of higher rates and slower inflation would mean the end of steep rate hikes in the UK. He added that “if we do slide into recession, then policymakers may be forced to reverse policy sooner than many expect”.
Last week’s Fed communication implied at least two further interest rate increases in the pipeline and Wells Fargo economist Jay Bryson said policy would “need to remain restrictive for quite some time” to bring inflation down. He forecast 25bps hikes at the next two FOMC meetings, but expects the Fed to be increasingly data-driven as it enters the “fine-tuning” stage of its tightening cycle.
Although US rates may be approaching their peak, the ECB has further to go. Katharine Neiss, chief European economist at PGIM Fixed Income, said more hikes were warranted due to the fact that the ECB was slow out of the gates with rate increases in 2022, in addition to “better-than-expected economic momentum” in the euro area this winter.
Market convictions tested
Even with more rate rises to come, US markets rallied following the dovish tone of chair Powell’s press conference. Some investors were encouraged by Powell’s relaxed approach to the recent easing in financial conditions, including his insistence that the Fed’s focus was not “on short-term moves”.
Laura Frost, investment director at M&G Investments, also noted that Powell “didn’t push back on the possibility of 50bps cuts toward the end of 2023”. These are already priced into the market – along with a lower terminal rate of 4.9 per cent.
The S&P 500 and Nasdaq rose 1 per cent and 2 per cent respectively following the FOMC meeting. The two-year Treasury yield dipped to 4.1 per cent, with prices moving inversely to yields as investors bought treasury bonds.
The FTSE 100 beat its 2018 peak and hit an all-time high in the days following the Bank of England meeting, as the index rose on the pound falling, the removal of references to “forceful” moves against the inflation rate and the outsize profits and new growth plans of the oil and gas majors Shell (SHEL) and BP (BP.). In contrast to earlier meetings, the Bank made no attempt to suggest that financial markets were misguided in their expectation for the path of rates this year. Sterling dipped to a one-month low of $1.20 against the dollar following the central bank meetings.
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