Parsing central bank communications is a hit and miss exercise. Sometimes the chosen language is a deliberate attempt to guide markets, at other times it is just a slip of the tongue. Clues for when interest rates will peak, and even start falling, are now key for investment and mortgage decisions. With inflation seemingly past its peak, this week the Federal Reserve, European Central Bank and Bank of England indicated that the end of their historic tightening cycle is in sight. They are now at a defining moment: stop hikes too late and deepen this year’s economic slowdown, or too soon and high prices could become entrenched. The risk of a mistake is high — and right now, their words are being examined closely.
Although headline inflation is falling, central bankers are still trying to square a number of circles before ending their rate hikes. The improved global growth outlook, pushed up in part by China’s reopening, will bring some price pressures. In Europe, the fall in natural gas prices will alleviate a major inflationary force, but it could facilitate more spending. Job markets remain tight too, adding to wage pressures. Central bankers also need to assess how much prior rate hikes are impacting the economy. Pulling together a convincing narrative of how everything plays out, and hence what terminal rate is appropriate is tricky — as mixed messages from central bank meetings this week conveyed.
The Fed slowed the pace of its rate hikes to 25 bps, noting that “ongoing increases” would be necessary to hit its inflation target. But Fed chair Jay Powell struck a more positive tone at the subsequent press conference. He said the “disinflationary process” was under way and did not push back against markets, which had priced in a lower peak in interest rates and even cuts later in the year. Indeed, although the Fed’s preferred measure of underlying price pressures eased further, job numbers rose unexpectedly on Friday, leading to a sell off in markets.
The eurozone is further behind in its inflation battle. The ECB raised rates by another 50 bps and committed to hiking by the same amount in March. President Christine Lagarde doubled down, saying “we have ground to cover”. After all, annual core inflation growth — which excludes food and energy — remains stubbornly high. Yet the bank’s statement contained softeners, conveying “more balanced” risks to the inflation outlook and ambiguity on what happens after March.
The BoE also hiked rates by 50 bps, ditching language that it would need to act “forcefully”, and forecast inflation to drop below target in 2024. This points to an imminent end to its rate rises. Yet the meeting minutes noted inflation risks are “skewed significantly to the upside”.
Amid the nuances, markets are not convinced about central bankers’ plans. Despite the rate rises, and scope for more ahead, investors chose to hear a dovish message and scaled back expectations of further central bank hikes. In the aftermath, equities and bonds soared, building on a rally over easing price pressures since the start of the year. This has loosened financial conditions, which is itself inflationary — further complicating central banks’ task. If inflation proves more persistent, and rates need to go higher, investors will be in for a nasty repricing.
Central banks’ recent slowing of rate hikes makes sense to better calibrate the peak rate as new data comes in. A sustained easing in core inflation and wage pressure may next persuade them to stop decisively. Clearer communication will also be more important, just as rate setting becomes ever more delicate in this rate cycle’s final stretch. But this will be challenging until central bankers can pierce through the uncertainty with more convincing forecasts.
