Last week we discussed how it will be difficult for central banks to achieve their inflation targets. A series of factors will likely keep core inflation, and eventually headline inflation, higher on average than in previous decades. Central banks will do as much as they can to bring inflation down to their targets, which tend to be around 2% in developed markets. But when inflation is between 3% and 4%, they will have to make a difficult judgment call. We also expect the ECB to increase rates twice more this year, probably in July and September. If inflation surprises to the upside significantly, we cannot rule out a further increase by the year’s end, possibly in December.
Finally, on Friday the BoJ will announce its own decision. In Japan inflation has been much better behaved than in other advanced economies; the country had after all been facing three decades of deflation. But recently inflation has been higher in Japan than in the US, for the first time in eight years. In spite of this, we do not expect the BoJ to make any meaningful change to its policy stance, though it might start to tweak the language in its policy statement to suggest that, in coming months, the Bank may be ready to phase out its flagship yield curve control (YCC) policy.
The following week, on 4 August, it will be the BoE’s turn to decide on its policy stance. After the surprise increase, by 50bps, that it carried out in June, following upon an unexpectedly sticky inflation reading, we expect the BoE to increase its Bank Rate by only 25bps, as inflation has in fact fallen to 7.9% from 8.7% the month before, more than the market had been expecting. The BoE remains the central bank in the most precarious position, considering how sticky inflation is in Britain when compared to other jurisdictions. This is also, in part, the result of the self-inflicted wound that was Brexit.
As we discussed last week, the other message that all central banks will try to give to market participants is that, once their terminal rate will be reached, they will keep rates high for longer than the market currently expects them to, so as to make sure that inflation has been tamed for good.
Should they try to make an extra effort to bring inflation down to 2%, while causing a major loss of output, an increase in the unemployment rate, and potentially causing financial instability episodes? Or should they give up their targets in order to preserve economic and financial stability as well as social cohesion? Each central bank will choose for itself, but we believe that, on average, most central banks will choose the first option.
While mulling over what to do in the medium term, the world’s major central banks are all meeting this week and next. They will start on Wednesday, when the US Federal Reserve will announce the outcome of its two-days FOMC meeting. As we discuss in our preview, we expect the Fed to increase its Fed funds target range by 25bps, as is widely expected by the market and has been signalled by Powell in previews weeks. This is likely to be the penultimate rate increase of the year, with the final one to be delivered between September and November, depending on how aggressive the Fed wants to be.
On Thursday it will be the ECB’s turn. The Governing Council will likely agree, unanimously, on a 25bps increase, which has been amply publicised in advance by ECB President Christine Lagarde. The ECB started its tightening cycle one year ago, four months after the Fed, and from a lower base than the Fed (the ECB’s deposit rate was -0.5%).
