The US Federal Reserve Board increased its key interest rate by half a percentage point on Wednesday, the first increase of this scale since 2000. And its chair, Jay Powell, has signalled that two similar increases at its next two meetings are likely. Interest rates are suddenly moving sharply off the floor – but a key thing to note is the uncertainty about how far and how fast this process will go.
The sharp rise in inflation, driven by the bounce back from Covid, supply chain problems and now the war in Ukraine, has ushered in a period of significant uncertainty. Some say US interest rates will top out at 3 per cent next year – but a minority feel they may need to go much higher to drive down inflation. In turns, this will be a key pointer to interest rates worldwide. A lot hangs on which forecast is right.
1. The Fed moves
The Fed’s decision to increase its key interest rate by half a point – to a new range of between 0.75 and 1 per cent – had been well flagged. And so stock and bond markets rose on the news. But perhaps it’s best to step back here. Markets were relieved that Powell said the Fed was not “actively considering” a 0.75 point rise at one of its upcoming meetings, even if he did not entirely rule this out. But by signalling two further 0.5 point rises at its next meetings in mid-June and late July, Powell is pointing to a pace of rate increases unseen in recent years. The Fed is responding to US inflation data showing an 8.5 per cent rate in March. But some influential economists argue it has left it too late to move – and will pay the price by having to push the US economy into recession to control runaway prices. Remember that as inflation rises, the real, or inflation-adjusted, cost of borrowing goes further and further into negative territory.
2. And the ECB?
Senior ECB officials have pointed out that underlying inflationary pressures have been stronger in the US than in Europe. Moving into 2022, US inflation was more broadly based – and less driven purely by the volatile elements of energy and food – and as the US is further ahead in the economic cycle, wage pressures were greater there than in the euro zone ( though in this respect Ireland is more like the US then the euro zone at the moment).
However, recent data has shown that inflation is spreading in the euro zone too. Headline inflation was 7.5 per cent in April, with a reading of close to 4 per cent when energy and food are excluded. The ECB expects inflationary pressures to ease, but as the war unfolds and with threats to oil and gas flows from Russia, we just don’t know.
Recently, influential ECB council member Isabel Schnabel said an interest rate rise by the ECB in July was "possible" because "now it's not enough to talk , we have to act". It is a major change from the start of the year when the ECB was guiding that no rate rise was likely in 2022. Analysts on balance continue to expect a gradual pace of ECB increases this year – bringing the deposit rate, now at minus 0.5 per cent, into positive territory, with the possibility of a rise in the main refinancing rate – from which tracker mortgages are priced – later this year.
However huge uncertainty hangs over the pace of ECB hikes, too. On one side, ECB forecasts now see headline inflation at 5.1 per cent this year but falling to just above 2.1 per cent next year. However, with the trend in energy prices very uncertain, adverse scenarios sketched out by the central bank are for an inflation rate of up to 7.9 per cent in 2022.
If this unfolds, then pressure will grow for a faster pace of rate increases.ECB chief economist Philip Lane, consistently on the dovish side in relation to interest rates, points out that disposable incomes and economic growth will also be hit by slower growth, particularly if energy costs rise further, and that this will hit demand and make the pace of interest rate increases uncertain – and dependent on how the economic data plays out. The latest figures show a fall-off in euro zone retail sales in March. As in the US, a vital point is the uncertainty.
3. Who would be a central banker?
The job facing central bankers is now near impossible. Balancing high inflation and slowing growth – stagflation – is very difficult for them, as higher interest rates threaten to slow growth further. After years of massive monetary expansion, what if central banks have left it too late, or there is simply no way of bringing down inflation without hitting growth?
Inflationary pressures have not come, from the most part, from the normal economic cycle, but rather from higher energy costs and now rising food inflation, messed up supply chains and a bounce back from a major pandemic. Central banks failed to see how inflation would build, though of course could not have anticipated the Russian invasion and the resulting spike in energy and food costs.
Higher interest rates do not address these factors, nor can they directly combat supply chain problems, now intensified by further Covid shutdowns in China.What interest rates can do is to bring down demand – and to signal to the public and businesses that inflation will not be let run out of control. And the expectations of where inflation will go are vital to how things turn out – the risk, in the jargon used by central banks – is that these expectations become “de-anchored”, in other words that the key players in the economy do not have expectations in line with central bank targets.
For years, the problem for the ECB was that everybody believed inflation would stay below the ECB’s 2 per cent target – that was identified as a major problem as late as 2019, when expectations for the long-term inflation rate were not far above 1 per cent. Now all has changed and the challenge is to make consumers and businesses believe that the current spike is temporary and should not be reflected in wage and price setting, thus becoming embedded.
And as inflationary pressures build, there are the aforementioned critics who argue that central banks have missed the boat, and are moving too late. Deutsche Bank, an outlier among key forecasters, argued recently that Fed interest rates would need to go as high as 5 to 6 per cent next year to control inflation, pushing the US economy into a sharp recession.
4. The consequences?
We are heading for a period of nervousness and volatile markets as central banks decide what bringing interest rates to “normal” levels looks like and whether this is enough to control inflation. In the US, entrenched inflation will keep the Fed under pressure. In Europe, a first rate rise in July is looking more likely and the pace of rate rises form there is in question.
Meanwhile, central banks will now certainly withdraw support for state borrowing quickly over the summer, which is likely to keep the costs of borrowing rising for national governments. Countries perceived as riskier will have to pay more to borrow as the ECB disappears as a backstop to the market – Italy is already facing a dangerous mix of higher borrowing costs and slowing growth.
More broadly, as the era of monetary expansion comes to an end, many of the asset prices supported by this process – houses, shares, commercial property, bonds and so on – could come under pressure. Not all will – other factors also play a role – but a big change is coming.
In the Republic, 10-year State borrowing rates have risen from just above zero at the start of the year to close to 1.7 per cent now. A move into the 2 to 3 per cent range looks likely in the months ahead. For the State and then for personal borrowers, the sums are changing quickly and the outlook is now really uncertain.
