Both the US Federal Reserve and the Bank of England raised rates last week and signalled that more increases are to come, as they look to curb accelerating inflation that now appears will remain higher for longer.
The ECB also surprised markets at its March meeting by tapering asset purchases more aggressively, despite increased risks to growth from the crisis in Eastern Europe.
The Federal Reserve raised the Fed Funds target rate by 25 bps on the upper bound to 0.5 per cent, their first rate increase since the end of 2018. The Fed now expects inflation to miss its 2 per cent target by a wide margin this year, upgrading its forecast for PCE inflation — its preferred measure — to 4.3 per cent from 2.6 per cent in December.
While the recent spike in energy and food prices probably contributed to this forecast change, the inflationary pressures in the US are becoming much more broad-based, and Fed chairman Jerome Powell characterised the labour market as “extremely tight”, which is also feeding through to higher wages.
Given the strength of the US economy, the interest rate projections from the Federal Open Market Committee show another six quarter-point rate increases this year. This implies an increase in interest rates at every meeting this year, although Mr Powell did not rule out a 50 bps increase at a future meeting if the outlook for inflation warrants it.
There are certainly some on the FOMC who favour a more aggressive tightening, with James Bullard voting for a 50 bps increase already last week. Another four rate increases are indicated in the dots plot in 2023, which would take the upper limit of the Fed Funds rate to 3 per cent by the end of next year.
This implies a higher peak in the rate increasing cycle than we saw in the 2018-19 cycle, which peaked at 2.5 per cent.
However, there is a high degree of uncertainty around the future path of interest rates. The range for the FOMC’s interest rate projections both for this year and next is very wide, with the 2022 outlook showing 1.4 per cent at the bottom end and more than 3 per cent at the top, while in 2023, the range extends from 2.1 per cent to 3.6 per cent.
The divergence in views suggests that the Fed’s outlook on inflation and the appropriate policy response may not be strongly unified.
In addition to higher interest rates, the Fed also indicated that it would likely start to reduce the size of its balance sheet at a coming meeting, and Mr Powell suggested that the pace of balance sheet reduction could be faster than was seen in previous cycles, implying that it could be equivalent to another 25 bps rate increase.
There is a clear cost to this tighter monetary policy — the Fed downgraded its growth forecast for 2022 sharply to only 2.8 per cent from 4 per cent previously. US growth is expected to slow further to 2.2 per cent in 2023 and 2 per cent in 2024.
However, this is not expected to have a negative impact on the labour market; the Fed expects unemployment to fall to 3.5 per cent by the end of this year and remain there through 2023, rising only fractionally to 3.6 per cent in 2024.
This is a key assumption, as maximum employment is the Fed’s other mandate. If slower US growth leads to rising unemployment in the country, then the Fed may need to recalibrate its expected path for interest rates going forward.
The Bank of England had a head start on the Fed by raising rates for the first time in December 2021. Last week’s 25 bps increase was the third increase and took the base rate to 0.75 per cent, reversing all of the pandemic-related rate cuts.
However, the tone of the Monetary Policy Committee was more dovish after the March meeting than it had been in February, with one MPC member voting to keep rates on hold this month and no votes for a 50 bps increase.
Policymakers are of the view that higher inflation will result in less discretionary spending and therefore softer demand and slower growth, and that monetary policy may not need to be tightened as much to curb inflation.
Emirates NBD expects two more 25 bps rate increases from the Bank of England this year, much less than the market is currently pricing.
The ECB sounded surprisingly hawkish at its March meeting, announcing it would taper asset purchases at a faster pace from April, despite the uncertainty and risks posed to economic growth by the conflict in Ukraine and sanctions on Russia.
ECB president Christine Lagarde and chief economist Philip Lane indicated that the ECB could raise rates in the fourth quarter of 2022. Again, however, uncertainty remains elevated and sharply slowing growth or a deterioration in the outlook on the back of the conflict in Ukraine could see the ECB delaying a rate increase into 2023.
Khatija Haque is chief economist and head of research at Emirates NBD
