Just one more hike for now?

The Federal reserve raised its rates again in May, by 25 basis points to 5.00–5.25%, indicating that it is prepared to pause its hiking after that, provided inflation keeps falling and the job market stabilises. Despite the conditions attached, this stance indicates a clear strategy shift away from the dogged fight against inflation. Other developed countries’ central banks are not far behind: the ECB and the Bank of England, which also hiked in May, may still add another round in June or even July, but are close to their targets of 3.75% and 4.75% respectively. Likewise, they are only prepared to pause their tightening if core inflation (excluding energy and food prices) drops – by no means a given either for the EU or for the UK.?

In emerging countries, rate rises started even before they did in the US and the eurozone. They are nearly completed in Latin America and well under way in Asia, even though core inflation is still a risk in some countries.

So the broad-based fight against inflation using frequent and sharp interest rate increases is reaching its conclusion in all regions except China and Japan, where monetary policy remains accommodative. A new variant of risks has taken over since the end of the pandemic and the start of the energy crisis due to the Russia–Ukraine conflict. In developed countries, strong growth and high inflation have now given way to weak economic activity, persistent inflation in services, and cracks in the financial sector. Central banks are now walking the tightrope between containing above-target inflation and managing a potentially systemic banking crisis.

Major central banks key rates: Pause after the tightening cycle

Stuck between inflation and financial instability?

Central banks have separated the issue of handling the banking crisis from the more straightforward fight against inflation. Their intermittent cash injections and forced consolidation of the sector kept the banking crisis somewhat in check while they carried on raising their interest rates, but prospects remain uncertain on both fronts, i.e. the financial health of US banks as well as the final victory over inflation. Like the consensus, we do not expect core inflation to ease back to 2% any time soon, and probably not until 2025. Central banks will have to trigger disinflation in services, an area that is less sensitive to key rate fluctuations, and will have to dampen demand through the job and credit markets. Demand for loans among eurozone and US firms has collapsed with credit supply tighter and lending conditions now stricter and likely to stay that way for the coming quarters. If central banks take a step back like they have with rates, they will indirectly be delegating to commercial banks the task of regulating final demand by controlling credit supply. The risks are either that a banking sector in turmoil will squeeze credit supply more than necessary, or on the contrary that heightened competition among banks will confine the tightening of demand to only a few sectors. Beyond any ?intervention by the Fed (potentially with a rate cut) and the regulators, solving the US banking crisis will call not only for intervention by Congress and an overhaul of medium-sized banks’ business models, but probably also for a strong consolidation. In short, the actions of governments and banks will determine where the balance is between financial stability and inflation.

Is the Fed still the trend-setter on rates?

While monetary policy has tightened in 2022 and early 2023, fiscal policy has remained expansionary with the support to households and industry – in response to the Covid and then the energy crises – keeping public deficits high. By 2024 budgets are likely to be reined in again as debt-servicing costs rise, rating agencies put pressure on both companies and governments, and the political will to control debt strengthens in the US (i.e. Congress) and the EU (renewed Maastricht criteria). Given this, should monetary policy remain hawkish it could slow the economy down further, and should it on the contrary cut rates too fast it could undermine the fiscal measures, neither of which would be conducive to stabilising the economic cycle, especially in an election year in the US. ??

Meanwhile emerging countries, although their outlook for the end of 2023 and 2024 is still not particularly strong (except for China), may find they have to start reducing rates as soon as inflation comes back down to their targets, which may well occur before the US and the EU get to that stage.?

As the supremacy of the US dollar, and indeed of the US itself, begins to be called into question, the desynchronisation between major regions’ monetary policies, growth rates and inflation trends is leading to increasing multipolarity and fierce competition between countries.

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