- After the European Central Bank raised interest rates to a record 4%, economists said they had probably peaked and the question now was how long they would stay at that level.
- Both the Federal Reserve and the Bank of England are expected to have at most one more interest rate hike in sight, but then end it.
- However, inflation is not expected to reach central banks’ 2% targets before 2025, putting further strain on budgets and risks to the outlook.
Christine Lagarde, President of the European Central Bank (ECB), at a press conference on the interest rate decision in Frankfurt on Thursday, September 14, 2023. The ECB raised interest rates again, curbing inflation in the increasingly weak euro zone economy for the tenth time in a row.
Bloomberg | Bloomberg | Getty Images
It is now widely accepted that the central banks of some of the world’s largest economies have reached or are close to reaching their highest interest rates.
The European Central Bank signaled last week that its Governing Council believes interest rates may have reached their target.
After much consideration of its updated inflation and economic growth forecasts and their implications for monetary policy, the ECB raised its key interest rate to a record high of 4%. While the accompanying statement by no means completely ruled out further increases, it said interest rates were at a level that, if maintained for a sufficiently long period of time, would make a significant contribution to the timely return of inflation to target.
The near-term inflation outlook remains bleak and is expected to hit households hard. The ECB’s macroeconomic forecasts for the euro area now call for average inflation of 5.6% this year, up from a previous forecast of 5.4%, and 3.2% next year, down from a previous forecast of 3 %.
But the 2025 forecast, one of the most closely watched metrics for measuring medium-term prospects, was cut to 2.1% from 2.2%.
The discussion will now shift to how long interest rates will remain at current levels, economists including Berenberg’s Holger Schmieding said following the announcement.
Analysts at Deutsche Bank said they wouldn’t see any cuts before September 2024, implying a 12-month pause at 4%.
However, challenges remain, including the prospect of significantly higher oil prices. Crude oil futures recently climbed to a 10-month high, which could affect the cost of goods and inflation expectations in Europe and the United States
Raphael Thuin, head of capital markets strategies at Tikehau Capital, said that despite the consensus about the end of the ECB hike cycle, “an alternative and less optimistic scenario remains possible: inflation is surprisingly strong and resilient and appears to be structural.”
“The recent disinflationary factors (goods and raw materials prices) appear to be running out of steam… There is a risk that, in the absence of a more convincing downward trend in prices, the ECB will consider its fight against inflation as unfinished “There is a risk of further interest rate hikes on the horizon” said Thuin in a note.
“In this respect, the development of macroeconomic data will be crucial in the next few weeks.”
Fed Chairman Jerome Powell made it clear last month that further interest rate hikes were on the table, and the central bank was deeply concerned that inflation could rise again as financial conditions eased.
In its June forecast, which is expected to be revised in an updated forecast this week, it said inflation would not reach 2.1% until 2025.
Monthly data shows continued price pressure. The consumer price index rose in August, mainly due to energy prices, at the highest monthly rate this year, reaching 3.7% year-on-year. Core inflation was 0.3% on a monthly basis and 4.3% on an annual basis, while producer price inflation recorded its largest monthly increase since June 2022.
However, markets are all but certain that the Federal Reserve will leave interest rates unchanged in September and are divided on whether there will be another rate hike this year. In a Portal poll of economists, 20% expected at least one.
“Given the relatively strong economic data and stubborn inflation, [the Fed] will maintain a restrictive bias,” economists at J. Safra Sarasin said in a note.
The Federal Open Market Committee “is likely to leave a final increase in its updated dot plot through year-end, although we don’t think it will ultimately implement it.” The dot chart refers to interest rate forecasts issued quarterly by policymakers to be made public to Fed decision-makers.
Markets continue to expect the Fed to cut interest rates next year, although some argue that this may be premature. In the same Portal poll, 28 economists expected a first cut in the first quarter, while 33 expected it in the second quarter.
The Bank of England is expected to make its final rate hike in September as it expects inflation to hit 6.8%, with signs of strain on the economy and renewed talk of a “mild recession”.
In its August report, the Monetary Policy Committee said it expected inflation to reach 5% by the end of the year, halve by the end of next year and reach its 2% target in early 2025.
“The bank is no longer in a clear environment where interest rate increases are clearly necessary,” he said Marcus Brookes, chief investment officer at Quilter Investors, points to weak gross domestic product data for July.
Analysts at BNP Paribas said they expected a final “easy rate hike” in September as wage growth and inflation pressures coupled with weaker economic indicators.
Wage growth figures held steady at 7.8% from May to July, remaining at a record level, but there were also signs of a slowdown in the labor market, with unemployment rising by 0.5 percentage points over the same period.
The mortgage market is another weak point, with delinquencies hitting a seven-year high in the three months to June.
James Smith, developed markets economist at ING, noted that both expected price growth and expected wage growth fell, while fewer companies reported struggling to find staff.
“A hike in November is possible, but assuming we are right about the direction of data flows and based on the BoE’s recent comments, we think a pause at this meeting is more likely,” Smith said.