John Fahey: Why core inflation will be a key determinant for rate decisions

Positive economic data has seen some renewed firming in market rate expectations over the last fortnight. Picture Denis Minihane.

It is a tricky balancing act for central banks in trying to engineer a slowdown in economic activity to lower inflation, by tightening monetary policy, without going too far in hiking rates, and having an even greater contractionary impact on demand. 

The IMF, as well as the OECD, amongst others, continue to warn about this risk, with the possibility that ‘sticky’ core inflation and tight labour markets could necessitate even higher rates.

During their current tightening cycles, the US Fed has hiked rates by 475bps so far, the Bank of England has raised rates by 415bps, while the ECB has executed 350bps worth of rate hikes. This has seen official rates rise to 4.875%, 4.25% and 3.00% in the US, UK, and Eurozone respectively.

More recently, central bankers’ policy deliberations have been further complicated by the stresses that emerged in parts of the global banking system in March and the substantial market volatility that followed. The aforementioned sharp rises in interest rates exposed financial vulnerabilities in some banks.

Stress in the banking sector could see a further tightening of credit conditions, which may in turn have a significant dampening effect on the real economy, especially in the US. The initial reaction to concerns about the banking sector saw markets anticipate fewer rate increases and earlier rate cuts, as a result of likely tighter credit conditions.

Global banking concerns

However, the recent easing of concerns in relation to the global banking sector, combined with some upside surprises to economic data has seen some renewed firming in market rate expectations over the last fortnight. Indeed, with central banks now espousing a data-dependent, meeting-by-meeting approach to their policy decisions, markets have become much more reactive to key data releases and central bankers’ comments.

We have seen examples of this recently. The higher-than-expected UK inflation for March, released last week, saw an immediate hardening of BoE rate expectations, with futures contracts now reflecting a view that the Bank rate could peak between 4.75-5.00%. The previous week, hawkish ECB comments saw Eurozone futures contracts envisage rates rising by 75bps (rather than 50bps), from their current levels.

Meanwhile, US futures contracts are now pricing in another 25bps increase from the Fed, whereas previously the market had started to assume the Fed funds rate had peaked. The market though continues to expect the Fed to start cutting rates in the second half of the year, although, the extent of rate cuts pencilled in for this year is now 50bps compared to 75bps at the end of March. The ECB and BoE are not anticipated to cut rates until the first half of 2024.

Overall, the outlook for official rates has a fair degree of uncertainty attached to it, with the trajectory of ‘core inflation’ being a key determinant, as well as evolving credit conditions in the banking sector.

What is certain, is that market rate expectations will remain sensitive to important data releases, especially in relation to inflation, central bank speakers' comments, as well as, any further issues in the global banking system.

John Fahey is Senior Economist with AIB