An end to central bank rate hikes now seems tantalisingly close. After the most rapid series of interest rate increases since the 1980s, the US Federal Reserve appears minded to halt its battle against inflation.
With characteristic central banking diplomacy, the Federal Reserve chair Jerome Powell recently said: ‘Having come this far, we can afford to look at the data and the evolving outlook.’ The consensus among economists is that the Fed will keep rates on hold at its June meeting, ending a string of 10 consecutive rate increases that has taken borrowing costs to the highest level in 16 years. At most, expect a final hike of 25 basis points.
Meanwhile the European Central Bank is thought to be only a few months away from also bringing rate hikes to an end.
‘After the rapid tightening, central bankers feel they should soon be able to step back and survey the damage’
Relentless
For CFOs, an end to rate hikes can’t come soon enough. The relentless string of increases on both sides of the Atlantic has intensified a range of risks for businesses. The greatest threat is that, in their zeal to bring inflation lower, central banks will bring about an economic slowdown.
With both the US and eurozone on track to grow by less than 1% in 2023, central banks are already dangerously close to pushing economies into a recession, which would undermine the consumer spending and business investment on which companies rely.
Then there is the increasing cost of capital. Even America’s most creditworthy companies, those with an investment-grade rating, have seen the cost of issuing debt rise from about 3% when the Fed first started raising rates in March 2022, to around 4.5% at the time of writing. That is up from a historic low of 1.4% in August 2020.
Finally, a dovish turn to monetary policy could also help fuel the recent rally in both the US and eurozone stock markets by making it easier and cheaper for companies to raise equity capital. While the link between interest rates and stock markets is far from direct and simple, much of the impetus for the rise in stocks has come from optimism that central banks will soon pause rate hikes.
Stubborn inflation
So what has convinced economists that an end to rate hikes is near? After all, inflation in both the US and eurozone is still well above the 2% target of both central banks. US inflation has slowed from a peak of 9.1% in June 2022 to 5% in April 2023. However, the latest measure of underlying inflation in the US was still running at 5.6% year on year in April after volatile food and energy prices had been stripped out.
Halting rate rises while inflation is still more than double the target rate may seem at odds with Powell’s repeated insistence in late 2022 that the Fed would ‘keep at it until the job is done’. Eurozone inflation has also been slower to decline than many had expected – core inflation in the region actually hit a new high of 5.7% in March.
Problems in the banking sector look like doing part of the central banks’ job for them
Shift in tone
Despite this, the tone of central bank commentary has been shifting. First, central bankers have been stressing that prior rate rises have yet to feed through fully into slower growth. While many companies and consumers locked in lower borrowing costs when rates were at rock bottom, eventually they will have to take out new loans at the higher current market rates.
‘After a period of rapid tightening, central bankers on both sides of the Atlantic feel they should soon be able to step back and survey the damage,’ says Andrew Kenningham, chief European economist at Capital Economics.
Second, inflation should start to fall more swiftly as the year progresses due to base effects. Current prices will then be compared to last year’s peak rates of 9.1% for June in the US and 10.6% in the eurozone for October.
Although the deceleration will come later in the eurozone, which had a delayed burst of inflation as regional gas prices spiked because of the war in Ukraine, more favourable year-on-year comparisons should help justify a pause in rates for the ECB too in coming months.
Third, the recent problems in the banking sector, starting with the collapse of Silicon Valley Bank in March 2023, look like doing part of the central banks’ job for them, reducing the need for further rate rises. As more regional banks struggle with deposit outflows, many have been more reluctant to lend, regardless of the interest rate. In May Powell underlined that the resulting tightening of credit conditions means ‘the policy rate may not need to rise as much as it would have otherwise to achieve our goals’.
Labour market
So far, so good, but the news is not all positive, says Kenningham. ‘With the labour markets still strong in both the US and eurozone, it may be some time before central banks feel able to start cutting rates,’ he says.
Wage rises, a key driver of inflation, remain uncomfortably high on both sides of the Atlantic. This is especially problematic in the eurozone, where key countries such as Germany have a convention of two-year wage agreements. ‘This means that if inflation has been high, pay settlements tend to lock in wage rises for longer,’ says Kenningham.
As a result, although economists see some scope for rates to start falling later this year in the US, Capital Economics is not forecasting cuts in the eurozone until the second half of 2024. Businesses may therefore face headwinds for some time to come.
