Central Banks: Next Steps in Fighting Inflation


ECB: All eyes are on the upcoming ECB meeting this Thursday when the next step in fighting persistent inflation in the eurozone will be announced. European money markets are pricing in a 50 bps hike for Thursday, thus taking the deposit rate to 2.5% and expectations are that the hiking cycle will be concluded in May 2023 with a peak rate of 3.25%. Hawkish comments from officials have followed one another, with the majority of the Governing Council endorsing a 50bps hike in the following meetings, arguing that current interest rate levels are still not restrictive enough. After having disclosed in December the size of the monthly reduction in the Asset Purchase Program holdings, we expect the specific breakdown of assets to be unwound will be detailed.

We have experienced quite a different environment since the December 2022 ECB meeting, with unusual mild winter temperatures and broad-based resilience in economic data. December inflation figures are clearly showing a cooling off in headline inflation, albeit relaying a more disquieting picture for price growth excluding energy and food (core measure). January core inflation is expected to come in softer versus January 2021, potentially reinforcing a levelling-off trend initiated in October 2022.


So while supply-side shocks are fading and gas storages in the 20 member states are filled at historically high levels, core inflation is still adjusting with a lag. Before getting overly enthusiastic, ripple effects from nominal wage negotiations and lifted government energy price caps could rapidly change the tone and potentially keep the ECB away from ending its rating cycle soon. In fact, looking at the ECB’s inflation projections of inflation at 3.4% in 2024 and 2.3% in 2025, its job is clearly far from done. Adding to this, the lower probability of recession has been supported by recent developments in industrial production data just above the pre-pandemic level, European manufacturer’s survey (composite PMI) moving back to expansionary levels and a large amount of excess savings accumulated during the pandemic. These ingredients are giving the ECB wider leeway to continue unabated in its mandate to reach price stability.


When the Fed released its December 2022 CPI data “econ twitter” resolutely sounded the victory bells. The third downward inflation surprise in combination with a persistently strong labor market gave online pundits and markets alike reason for optimism. Even famously hawkish St. Louis Fed president James Bullard stated the odds of a soft landing have “markedly improved”. Economic outlooks have certainly improved since the doom and gloom of last fall, but it’s important to recognize plenty of stumbling blocks remain for the rates environment to improve. The outcome of the coming February meeting appears to be certain; a 25bps hike is openly supported by several members of the board of governors and markets are pricing in such a hike almost exactly. Future Fed meeting outcomes diverge much more widely, and therefore the notes are likely to be much more interesting. Markets currently price in rate cuts by as soon as July this year. In contrast, Fed staff have frequently stated they will do no such thing. Whilst it may be in the best interest for the Fed to overstate its intent for rate hikes, there are good reasons to see this as credible. Services inflation excluding cost of shelter, a common proxy for the cost of labor, is still elevated at 0.46%. The US labor market has thus far shown no signs of slowing down in recent data despite sharp increases in rates over the past half year. For example, initial jobless claims decreased by 4,000 compared to previous figures, non-farm payrolls increased by 223,000, and continuing claims have only risen by 28,000. Continued labor market strength would present the Fed with the risk of ex-shelter services prints flaring up again if it is to cut any time soon. With the outcome of the next meeting seemingly set in stone, the minutes are likely to be of most interest.


The Bank of England will be making another interest rate decision on 2 February with the current policy rate at 3.50%, and the market expects a 90% chance of a 50bps increase. Large increments seem to be the norm these days, after the last four meetings resulted in three 50bps and one 75bps moves.

However, if we take a step back, it is still rather unusual for policy rates to be increased in these large steps. It rather used to be hikes in small steps and cuts in large ones. The rationale amongst policy makers was to increase in large steps so it was not necessarily about getting to a higher peak rate, just to get there quicker so less is needed in the long run. Our expectation for the BoE is that they are indeed coming toward the end of the hiking cycle, but with little commentary from the Monetary Policy Committee members it is quite difficult to gauge the exact timing and peak of the policy rate. Nonetheless, we expect it to be lower than the market and think it is entirely plausible that February could be the last hike.


Another difficulty is that nine Monetary Policy Committee members who vote on policy rates are split, last time into three camps: two are in favor of holding, six of a 50bps hike and one a 75bps hike. It’s a guessing game as they are all looking at different types of data. Some are interested more in wages and inflation expectations while others think we are already in restrictive territory and want to take time to see how the long and variable lags of monetary policy work its way through the economy.  

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