Traders react as Federal Reserve Chair Jerome Powell is seen delivering remarks on a screen, on the floor of the New York Stock Exchange (NYSE) in New York City, March 22, 2023.
Brendan McDermid | Reuters
The market has long been pricing in interest rate cuts from major central banks toward the end of 2023, but sticky core inflation, tight labor markets and a surprisingly resilient global economy are leading some economists to reassess.
Stronger-than-expected U.S. jobs figures and gross domestic product data have highlighted a key risk to the Federal Reserve potentially taking its foot off the monetary brake. Economic resilience and persistent labor market tightness could exert upward pressure on wages and inflation, which is in danger of becoming entrenched.
The headline U.S. consumer price index has cooled significantly since its peak above 9% in June 2022, falling to just 4.9% in April, but remains well above the Fed’s 2% target. Crucially, core CPI, which excludes volatile food and energy prices, rose by 5.5% annually in April.
As the Fed earlier this month implemented its 10th increase in interest rates since March 2022, raising the Fed funds rate to a range of 5% to 5.25%, Chairman Jerome Powell hinted that a pause in the hiking cycle is likely at the FOMC’s June meeting.
However, minutes from the last meeting showed some members still see the need for additional rises, while others anticipate a slowdown in growth will remove the need for further tightening.
Fed officials including St. Louis Fed President James Bullard and Minneapolis Fed President Neel Kashkari have in recent weeks indicated that sticky core inflation may keep monetary policy tighter for longer, and and that more hikes could be coming down the pike later in the year.
The personal consumption expenditures price index, a preferred gauge for the Fed, increased by 4.7% year-on-year in April, new data showed Friday, indicating further stubbornness and triggering further bets on higher for longer interest rates.
Several economists have told CNBC over the past couple of weeks that the U.S. central bank may be forced to tighten monetary policy more aggressively in order to make a breakthrough on stubborn underlying dynamics.
According to CME Group’s FedWatch tool, the market currently places an almost 35% probability on the target rate ending the year in the 5% to 5.25% range, while the most likely range by November 2024 is 3.75% to 4%.
Patrick Armstrong, chief investment officer at Plurimi Group, told CNBC last week that there was a double-sided risk to current market positioning.
“If Powell cuts, he probably cuts a lot more than the market’s pricing, but I think there is above 50% chance where he just sits on his hands, we get through year-end,” Armstrong said.
“Because services PMI is incredibly strong, the employment backdrop incredibly strong, consumer spending all strong — it’s not the kind of thing where the Fed really needs to pump liquidity out there unless there is a debt crisis.”
European slowdown
The European Central Bank faces a similar dilemma, having slowed the pace of its hiking increments from 50 basis points to 25 basis points at its May meeting. The bank’s benchmark rate sits at 3.25%, a level not seen since November 2008.
Headline inflation in the euro zone rose in April to 7% year-on-year, though core price growth posted a surprise slowdown, prompting further debate as to the pace of rate rises the ECB should be adopting as it looks to bring inflation back to Earth.
The euro zone economy grew by 0.1% in the first quarter, below market expectations, but Bundesbank President Joachim Nagel said last week that several more rate hikes will be needed, even if that tips the bloc’s economy into recession.
“We are in a not at all easy phase, because inflation is sticky and it’s not moving as we would all hope it would, so it’s quite important as Joachim Nagel said today that the ECB stays open for further rate hikes as long as it needs until the drop-off is done,” former Bundesbank executive board member Andreas Dombret told CNBC last week.
“Of course, this will have negative implications and negative effects on the economy too, but I strongly believe that if you let inflation [de-anchor], if you let inflation go, those negative effects will be even higher, so it is very important for the credibility of the ECB that the ECB stays the course.”
The Bank of England
The U.K. faces a much tougher inflation challenge than the U.S. and the euro zone, and the U.K. consumer price inflation rate fell by less than expected in April.
The annual consumer price index dropped from 10.1% in March to 8.7% in April, well above consensus estimates and the Bank of England’s forecast of 8.4%. Meanwhile core inflation jumped to 6.8% from 6.2% in March, which will be of greater concern to the Bank’s Monetary Policy Committee.
With inflation continuing to prove stickier than the government and the central bank had hoped, now almost double the comparable rate in the U.S. and considerably higher than in Europe, traders increased bets that interest rates will need to be hiked further in order to curtail price rises.
“Supply shocks, still de-anchored inflation expectations, fewer promotional discounting, and some potential margin building are likely keeping prices from normalising as quickly as traditional models would imply,” explained Sanjay Raja, chief U.K. economist at Deutsche Bank.
“We now expect a slower descent to target, and with price and wage inflation now likely to remain stronger than anticipated, we raise our terminal rate forecast to 5.25%. Risk management considerations will, we think, force the MPC to push rates higher and further than previously intended.”
Deutsche Bank now sees monetary policy shifting “firmly” toward a “higher for longer” era, Raja added.
The market is now pricing a 92% chance of a further 25 basis point rate hike from the Bank of England at its June meeting to take the main bank rate to 4.75%, according to Refinitiv data on Friday afternoon.
But despite the expectations for rates to rise further for longer, many economists still see a full reversal of course before the end of this year.
Berenberg had previously projected three cuts by the end of 2023, but cut this down to one in response to last week’s inflation print.
The German bank kept its end-2024 call for a 3% rate unchanged, projecting six 25 basis point cuts over the course of next year, but also put a 30% probability on a further 25 basis point hike in August to take the bank rate to 5%.
“Policy changes operate with uncertain effects and variable lags. As a consequence of the shift away from floating-rate mortgages towards fixed products over the past decade, the pass-through of monetary policy to consumption via the housing market takes longer than in the past,” said Berenberg Senior Economist Kallum Pickering.
“This highlights the risk that, if the BoE overreacts to near-term inflation surprises, it may set the stage for a big inflation undershoot once the full effects of its past policy decisions play out.”