The US Federal Reserve held its FOMC meeting last week. As we discussed in our review, the Fed increased its Fed funds target rate by 25bps, to 5.00%-5.25%. We – as well the consensus opinion – consider this to be the last increase before a pause that is likely to last at least until the autumn. The Fed is also continuing its policy of reducing its balance sheet, according to the criteria it established in May 2022.
As we discussed in our review, the Fed retained a hawkish bias with this decision. It made it clear that it could further increase its rates if the economy proves to be more resilient, the labour market tighter, and inflation stickier than is currently expected. A condition for this to happen is the absence of further negative surprises from the banking sector. This cannot be taken for granted at this stage, as regional banks remain vulnerable to a downturn in residential as well as commercial real estate, and all banks remain exposed to much higher interest rates. In spite of the Fed’s hawkish bias, the market celebrated with a relief rally, especially in bonds. It has been perceived as the end of the hiking cycle – at least for a while.
Also last week, the ECB held its Governing Council (GC) meeting, and decided a 25bps increase in its policy rates. It also decided to accelerate the shrinking of its balance sheet, given the end of the re-investment of maturing bonds from July 2023. Unlike the Fed, the ECB has signaled that further hikes will likely be necessary to tame inflation, which remains stubbornly high at three times the ECB’s target level. But with a couple of more hikes in June and July, the ECB too will likely have finished its initial hiking phase.
The Reserve Bank of Australia meanwhile carried out a surprise rate increase of 25bps, to 3.85%, because inflation, at 7%, is still too high compared to its target, even if it has passed its peak.
This week, it will be the Bank of England’s turn to increase its Bank Rate, again by 25bps, to 4.25%, to try to bring inflation down to single digit levels. Inflation remains above 10% in the UK, impacted not just by the re-opening of the economy and the energy shock, but also by the effects of Brexit on British supply chains.
In spite of the different jurisdictions, it is clear that central banks, especially in the developed world, have now reached, or are about to reach, a local peak in their increases of interest rates. The Fed has increased rates by 500bps in a little more than a year. The hiking cycle has been rapid, large and coordinated, to an extent unseen in recent decades.
The side effects of this massive tightening in policy rates conducted at global level has started to appear in terms of financial instability, with banks suffering a level of interest rates that may be beyond what the Fed has called a “financial (in)stability rate.” Central banks will now have to try a difficult balancing act between slowing growth, persistently high inflation, and incipient financial instability. Not an easy job, surely.
