Eurozone central bank governors enjoyed a night out dancing to the theme song from Zorba the Greek last week after they met in Athens and unanimously agreed to stop raising interest rates for the first time in 15 months.
The rate-setters could be forgiven for letting their hair down after the surprisingly harmonious meeting. Even the most hawkish members of the European Central Bank’s governing council went along with the decision to forgo another increase in borrowing costs, following a steep drop in inflation in the single currency area.
“It was the quietest discussion we have had for many months,” recalls Yannis Stournaras, governor of the Greek central bank, who hosted last week’s gathering. “It is so obvious that we have tightened monetary policy enough”.
The ECB was not alone in opting for a freeze. The US Federal Reserve, the Bank of Canada, and the Bank of England all kept policy unchanged in recent days, joining central banks in countries ranging from Czech Republic to New Zealand. Central banks in some emerging markets including Brazil and Poland are engaged in outright cuts.
The halt in the rate-rising cycle has sparked a flurry of optimism among bond market investors that leading economies are close to vanquishing the inflationary upsurge, after consumer price growth more than halved from its peak levels in economies including the US and euro area. Jari Stehn, Goldman Sachs’s chief European economist, says there is “a growing view that the inflation problem is now under control — and I would say rightly so.”
Yet that celebratory air has been noticeably absent among the presiding central bankers themselves — leaving aside the revelries in Athens. In recent days ECB president Christine Lagarde, the Fed’s Jay Powell, and Andrew Bailey of the Bank of England all continued to insist further increases in rates remain on the table despite signs that consumer price inflation is subsiding.
That in part reflects a desire to push back against investors who might otherwise drive down yields and loosen financial conditions, undermining the campaign to squash price growth. It also reflects genuine uncertainty over whether the recent data marks a conclusive turning point, especially given central banks’ past forecasting failures and fears that a volatile geopolitical environment could throw up fresh price shocks.
Joseph Gagnon, a former senior staffer at the Fed who is now at the Peterson Institute for International Economics, says central banks are now at an “inflection point” and that this is a point of minimum — rather than maximum — confidence in the outlook.
“When you know you’re behind the curve and you better raise rates fast to catch up, you have a lot of confidence that you’re doing the right thing,” he says. “But then as you approach where you think you might have done enough, that’s when you’re less certain about the next move. That’s where they are.”
Playing it safe
The caution is understandable after central bankers were so badly wrongfooted by inflation two years ago. The rapid bounceback of consumer spending following the lockdowns, coupled with the lingering effects of supply chain shortages, the massive US fiscal stimulus, and the energy price shocks stemming from the Ukraine war all helped inflame the worst eruption of inflation for decades among big economies.
It was an outbreak that central banks were slow to recognise until they realised it risked detaching inflation expectations from their cherished 2 per cent targets.
Policymakers at the Fed, ECB, BoE and other central banks embarked on a frenetic succession of rate rises starting around two years ago that has left borrowing costs in Europe and the US at their highest levels since before the financial crisis.
In the US, that brutal set of rate rises has helped curb CPI inflation to 3.7 per cent, far below a peak that neared 10 per cent. Yet the Fed is still dealing with a surprisingly effervescent economy that recorded annualised growth of 4.9 per cent in the most recent quarter.
Despite higher prices and shrinking savings buffers, consumer spending has not yet materially slowed. That is in large measure due to a robust labour market, although a weaker-than-expected October jobs report on Friday suggests some moderation lies ahead.
Speaking at a press conference this week following the Fed’s decision to forgo a rate rise for its second-straight meeting, Powell was adamant that it had not closed the door to further monetary tightening. “We’re not confident at this time that we’ve reached such a stance,” he said in response to a question on whether rates are now sufficiently restrictive.
Yet Powell did not put markets on notice that any tightening is imminent, prompting investors to draw their own conclusions, as they shift to speculating about how soon rate cuts may come.
Powell insisted that the Fed was not even entertaining the idea of when to cut rates. But increases in long-term rates over recent weeks, driven by factors including concern about hefty government borrowing, have helped to tighten financial conditions significantly, bolstering the case that the Fed can stand still for the time being.
The Fed chair acknowledged that this could obviate the need for the central bank to take additional steps to restrain economic demand, although much would depend on how persistent the market moves turned out to be.
Having been widely criticised for being too slow to react to the biggest inflation surge for a generation last year, the ECB is also — like the Fed — deeply reluctant to declare victory over inflation prematurely. “The last thing the ECB wants to do is to make the same mistake by underestimating inflation for the second time in two years,” says Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.
But the case for European rates having peaked is, if anything, even stronger than in the US. The eurozone economy contracted 0.1 per cent in the third quarter, while inflation in the single currency bloc also fell below 3 per cent for the first time in more than two years.
ECB board member Isabel Schnabel warned in a speech on Thursday that “the last mile” of the disinflation process “will be more uncertain, slower and bumpier” and risked being destabilised by “supply-side shocks” such as the Israel-Hamas conflict. “We cannot close the door to further rate hikes,” she said.
Nevertheless, market discussion now centres not on whether further hikes lie ahead, but rather how soon the ECB’s first cut will come. Economists expect its rate-setters to wait for clear evidence that inflation has been tamed before cutting rates. This may hinge on whether collective wage agreements with unions next spring show an easing of pay growth — a vital step to bring down core inflation, which excludes energy and food, from its current level of 4.3 per cent.
If headline eurozone inflation heads sustainably below 3 per cent, Stournaras reckons a rate cut could come “in the middle of next year”.
For the Bank of England, the dilemma ahead is more nettlesome. The bank downgraded its views of both UK output and supply in its November forecasts on Thursday, as it held rates at 5.25 per cent, warning that pay pressures remained more resilient than it had expected and that unemployment may have to rise further than expected to bear down on prices.
Its outlook was grim, portending flatlining growth, coupled with above-target inflation until late in 2025. Bailey said his rates committee reserves the right to lift rates again if needed, but many investors see a further increase as highly unlikely given the weakness of the economy and signs of a cooling labour market.
Tiffany Wilding, managing director at Pimco, says that while headline inflationary trends in Europe have been one or two quarters behind the US, economies were now heading in the right direction on both sides of the Atlantic.
But she adds this does not necessarily mean that they are entirely out of the woods, in part because the main reasons for the decline in inflation are “pandemic-related effects fading” — for example the ending of supply chain snags and an ebbing tailwind from fiscal policy.
“What central banks are still a little bit worried about is that once we have these pandemic-related distortions on inflation that fade, where is the underlying trend in inflation?” she asks. “How much labour market pain do you need to really get [inflation] back down?”
Given a volatile geopolitical environment that threatens to throw up fresh supply shocks, and the prospect of fragmenting supply chains amid rising trade tensions, claims that inflation has been definitively quelled could quickly look like wishful thinking.
“I don’t think that any of them are ready to put up a banner that says ‘mission accomplished,’” says Seth Carpenter, who previously worked at the Treasury department and the Fed and now at Morgan Stanley.
“I think the past two-and-a-half years have shown just how difficult forecasting can be, and I do think there is a sufficient dose of appropriate humility across central bankers about how hard it is to know for sure where things are going.”
Additional reporting by Mary McDougall in London
Data visualisation by Keith Fray