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SPI Management Newsletter 16.06.23

Fed Pauses on Interest Rates, Plans for Future Increases

Despite a streak of ten straight increases, the Federal Reserve has decided to hold interest rates steady, with officials suggesting future raises are likely if the economy and inflation do not abate. This decision indicates an inclination to slow the pace of hikes, not to stop them completely. The majority of officials anticipate two additional rate hikes this year, taking them to a 22-year high.

Since March 2022, following the Covid-19 pandemic, the Fed had implemented a consistent rise in the rate at every meeting, totalling a cumulative 5 percentage points. However, 2023 has seen a slowdown, with only a quarter percentage point rise at the last three meetings. Fed Chair Jerome Powell indicated that the recent decision not to raise rates is a continuation of this slower process, justified by how close they believe they are to their final destination. The market responded with mixed reactions, with minor fluctuations in major stock indices.

Internal disagreement among officials about the necessity of future rate hikes has surfaced recently. Some officials expressed doubts about the need for more rate increases after March's Silicon Valley Bank incident, fearing a potential credit crunch.

Others, including Powell, remained concerned that inflation, hiring and consumer spending had not sufficiently slowed down. Powell suggested a potential compromise could be bypassing a June rate increase but keeping the option open for a potential hike at the July meeting. This discrepancy in views makes communication about the central bank's future moves more complex.

The economic data on hiring and inflation has been stronger than many forecasters expected, adding another layer of complexity to the situation. If the economy performs as per their expectations, most officials think they'll need to raise rates to between 5.5% and 5.75% this year. However, there are some who anticipate rates could remain at current levels for the rest of the year.

ECB Hikes Interest Rates diverging from Fed

On Thursday, the European Central Bank (ECB) surprised markets by raising interest rates by a quarter percentage point, suggesting more increases are in store, pushing the euro to surge. This assertive move is starkly different from the Federal Reserve's decision to hold rates steady, which was announced on Wednesday.

According to ECB President Christine Lagarde, the central bank is not satisfied with the inflation outlook and will continue to hike rates unless significant changes in economic data emerge. The ECB's strategy appears to shift from large, monthly rate hikes to a more nuanced approach, scrutinizing recent economic data to measure the effect of past rate adjustments.

The ECB announced that its key deposit rate would increase to 3.5%, the highest level in over two decades. This move, the eighth consecutive rate increase, was expected by investors. However, Lagarde's strong indication of another rate hike next month and an upward revision of the underlying inflation forecast through 2025 caught investors off guard, leading to a rise in the euro's value.

While inflation remains high in many developed economies, there are indications that previous rate hikes are starting to stabilize housing markets and lower unemployment rates. Central banks worldwide are re- evaluating their strategies, with countries like Australia and Canada recently implementing surprising interest rate increases.

Investor expectations for central banks' rate heights have been on the rise as growth resumes in countries like Canada, Sweden, Japan, and the U.K. Current forecasts indicate the ECB will make one or two more rate hikes, followed by cuts early next year. As the U.S. experiences solid economic and job growth, the eurozone is heading into a mild recession, which could impact inflation rates.

Central banks are facing the challenge of estimating how previous rate decisions will affect future inflation, as monetary policy impacts tend to lag. Although higher rates and decreasing food and energy prices help combat inflation, tight labor markets are driving wages up, potentially pushing inflation higher.

Adapted from WSJ, FT, NYT, Reuters, Al Jazeera

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