Download the PDF
This week saw the US Federal Reserve (Fed) pause it current rate-hike cycle, while the European Central Bank (ECB) raised their policy rate by 25 basis points (bps). Both moves were anticipated by commentators and the market. The Fed’s decision appears to be motivated by a “let’s-take-stock of where we are” approach. Having raised the fed funds rates by 500bps in little over a year, the Fed has decided to pause and give space to see what effect the rate hikes to date are having on the economy and give themselves a chance to assess the fall out of the banking crisis.
Underlying central bank policy remains concerned over elevated rates of inflation. The Fed received news that the annual rate of US headline inflation fell from 4.9% in April to 4.0% in May, slightly lower than expectations of 4.1%. And although core inflation also fell, its fall was far less than that of headline inflation. The annual rate of core inflation fell a miserly 0.2 percentage points, dipping from 5.5% to 5.3%.
The inflation data was important in that it didn’t give the Fed a smoking gun that would have forced them to raise rates at this meeting. But at the same time, the core inflation didn’t confirm that the inflation genie is definitively back in the bottle and so the prospect of future rate hikes is still well-and-truly on the table.
In fact, the Fed’s upgrade of its economic outlook and its forward guidance over future rate movements indicated the Fed is anticipating another two 25bps rate hikes from here. Given the resilience of the US labour market, (US payrolls data showed over 300k jobs were added in May), and the stickiness in core inflation, it is highly likely the Fed will revert back to their hiking cycle with a 25bp hike at their next meeting in July: a move that most commentators and the market are expecting.
Will the Fed follow through with another hike after July? We don’t think so. Where we and the market disagree with the Fed is the likely extent of the economic slowdown over the second half of the year. The Fed expects growth to slow to an annual pace of 1% by year end, whereas we and the market expect growth to slow to a measly 0.2% annual pace.
In our view, the prospect of rate hikes beyond July will come down to who’s right on the US growth outlook. We and the market are in the recession camp, hence, our view that the Fed can only afford one more rate hike in July unless it wishes to drive the US economy into a deeper recession than is necessary to get inflation back close to its target by mid-2024. The Fed is in the soft landing (no recession) camp and hence, if they are right, there are more rate hikes to come.
In contrast to the Fed, the ECB, pushed ahead with rate hikes, raising the deposit facility (the ECB’s main policy rate) by another 25 basis points. ECB President Lagarde also gave clear forward guidance that the ECB is not done yet, flagging another rate hike to come in July, despite the euro area economy being in technical recession. Like the Fed, the ECB is getting close to its terminal rate and we see a 25bp July rate hike as being the last in the current tightening cycle. However, should they be hiking at all given the weakness in European growth?
The soft quarters of growth over winter (and we’re talking about the smallest of negatives -0.1% and -0.1%) were to be expected given what’s happened to energy prices in the wake of the Ukraine/Russa war, and even though growth was negative, the outcome was far better than was expected even just a few months ago. More recently, we’ve seen the European economy picking up a tad over June. As in the US, euro area core inflation remains sticky and the ECB will want to ensure that core inflation is on a sustainable downward trend before they pause.