Oliver Mangan: Central banks to keep the pedal to the floor over rate hikes

Banks indicating policy will need to be kept tight for a long time to return inflation to target

Mon, 27 Feb, 2023 - 13:57

The shift by global central banks to smaller rate hikes is not a signal that monetary tightening is about an end — they have continued to emphasise the battle to bring inflation back under control and restore price stability is far from won.

They have been guiding that further hikes are on the cards and rates will need to go higher than previously anticipated, moved to quell expectations of rate cuts before year-end, and indicated policy will need to be kept tight for a long time to return inflation to target.

US Federal Reserve

The US Federal Reserve opted for a quarter point rate hike at its last policy meeting in early February, bringing the target range for the funds rate up to 4.5% to 4.75%. The Fed’s interest rate projections from December revealed near unanimity on its monetary policy committee that rates will need to rise above 5% in 2023.

Since then, US data have printed on the strong side, leading markets to start pricing in that rates will be hiked to a 5.25% to 5.5% range by mid-year.

Further out, markets have greatly scaled back their expectations on rate cuts. They now see rates ending the year at 5.25%, compared to 4.5% in mid-January, and futures contracts see rates being cut to about 4% by the end of 2024.

Bank of England

Meanwhile, the Bank of England hiked rates by half a point in early February, bringing the bank rate up to 4%. There were expectations at the time it would do one more quarter point hike and then put policy on hold. However, the bank noted further rate increases would be required if there was evidence of persistent inflationary pressures.

UK data have been coming in ahead of expectations recently, while wage inflation remains high amid tightness in the labour market. Thus, futures contracts are currently envisaging a peak in rates at 4.75% this summer, and only modest rate cuts are envisaged in 2024 to 2025.

European Central Bank

The European Central Bank has given a clear signal that rates will be hiked by half a point at its March meeting, bringing rates up to 3%.

Market expectations for the peak in ECB rates have firmed considerably, and future contracts now see rates rising to at least 3.75% this summer, up from 3.25% previously. Markets look for a modest easing of three quarter points during 2024 and 2025.

Markets have lifted their expectations of the peak or terminal rate across markets in the past month.

However, of greater significance is that they now expect rates to remain elevated over the medium term. The risk to this view is if the time lag in terms of monetary policy impacting economic activity is being underestimated by central banks and markets.

This could see both growth and inflation turn out to be much weaker than anticipated in the coming year, which would set up the prospect of significant rate cuts in 2024 and 2025.

For now, though, stronger than expected data will encourage central banks to keep the pedal to the floor and continue hiking.