Central bankers faced a dramatic shift about a year ago. For over a decade their primary concern was fighting low and negative rates and heavy borrowing. Inflation ran persistently above a target of 2 percent, viewed as optimal for sustainable growth. Last summer an inflationary spiral appeared and at first was dismissed as temporary. A year later it could not be contained, driven in part by the war in Ukraine. Now the pressure is to decide whether to keep tightening to tame prices or ease off to avoid tipping the economy toward recession.
This conflict will be a central topic at the annual Jackson Hole summit in Wyoming, hosted by the Federal Reserve Bank of St. Louis since its early years and again gathering top officials in person after a two-year hiatus. The gathering runs from Thursday through Saturday. The market will be watching closely when the Federal Reserve chair, Jerome Powell, speaks on Friday. With expectations that rate hikes might slow after a market rally, investors have paused in recent weeks as they await Powell’s message about the next steps for monetary policy.
review expectations
The Federal Reserve has raised the target range for the federal funds rate to 2.25 percent to 2.5 percent for the year. After a 0.75 percentage point increase in July, traders speculated about a 0.5 point move in September followed by smaller rises. Yet some analysts worry a 0.75 point hike could reappear, a scenario highlighted by policymakers from the Atlanta and Kansas City Federal Reserves, Raphael Bostic and Esther George, in recent commentary.
In a climate of high inflation that defies short term predictability, the Fed has prioritized price stabilization and remains ready to tighten further. Franck Dixmier of Allianz Global Investors noted that markets are still likely to revise their expectations upward if rate hikes peak later than previously thought, potentially bringing more volatility.
different situations
The United States appears in a different position from Europe. The euro has weakened against the dollar, and the U.S. economy has posted back-to-back quarterly declines, though not enough to declare a recession. The government and the Federal Reserve have signaled that a recession is not yet in progress, with room to tighten further if conditions warrant.
Inflation has shown signs of cooling, easing from highs earlier in the year, while unemployment remains low and job openings stay plentiful. Analysts broadly expect continued rate increases to the 3.5 to 3.75 percent range by year end or early next year, though policymakers could alter course after Powell’s remarks. The Kansas City Fed chair has allowed the possibility of moving above 4 percent, at least temporarily, depending on incoming data.
harsh winter
Europe faces a divergent path. The European Central Bank has indicated no rate hike before the autumn, with the reference rate hovering around a low level as energy costs dominate the inflation picture. Inflation across the euro area has remained stubbornly high, touching near 9 percent in mid year, even as some countries show softer growth while others edge toward recession. Unemployment remains near historical lows, but growth has slowed, signaling a fragile balance ahead.
A looming risk is an interruption in Russian gas supply to Europe, with Germany heavily dependent on energy imports and manufacturing. ING analysts point out that energy prices drive inflation in the near term and that a peak above 9 percent seems plausible, while movements could push beyond 10 percent under extreme conditions. In Spain, inflation has already surpassed 10 percent in places.
room to harden
Most evidence suggests the ECB will not loosen its pace of rate hikes soon. Isabel Schnabel, a senior member of the executive board, said that a 50 basis point increase in July reflected the inflation outlook and did not indicate a radical change in stance. The ECB is expected to stage a similar intervention at Jackson Hole, with officials not ruling out a recession yet insisting the downturn would not necessarily be long or deep. In other words, there seems to be room to tighten further if needed.
Markets currently anticipate a rate level around 1.5 to 2 percent early next year. That may not sound high relative to consumer price measures, but it is important to weigh that rate policy aims to cool inflation by lessening demand, while the causes of higher prices can vary, including energy pressures.
If the economy slows sharply and demand weakens, policy may have to rely on the balance of supply rather than simply higher rates. The ultimate level of rates will depend on the trajectory of Russian gas supplies and the persistence of inflation, strongly influenced by the war in Ukraine and its effects on activity. The central banks nonetheless face a challenging mix of risks as weathering the storm continues.