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Central Banks Navigate Inflation Dilemma as Interest Rates Near Peak Levels


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Inflation Challenges for European Central Banks

High inflation continues to be a problem for households and businesses in Europe, and central banks in the region are struggling to bring it down to target levels.

In September, there was a change in tone from some central banks as they paused interest rate hikes after almost two years, while others seemed to be reaching peak rates. This has shifted market attention to how long rates will remain at current levels, considering the challenges faced by economic growth.

Carsten Brzeski, global head of macro at Dutch bank ING, stated, “All central banks are dealing with the same triple dilemma: balancing slowing economies, high inflation, and the delayed impact of previous rate hikes. Another common theme is that interest rates in all regions are very close to their peak, which complicates this balancing act.”

The recent increase in oil prices adds to the difficulties, potentially fueling inflation while slowing down economic growth and making future interest rate decisions even more challenging.

Pause in the U.K.

The Bank of England (BOE) decided to pause interest rate moves after 14 consecutive hikes, keeping its main policy rate at 5.25%.

The decision was a close call, with five members of the Monetary Policy Committee voting to hold rates and four in favor of another 25 basis point hike. The lower-than-expected August inflation data, showing a year-on-year inflation of 6.7%, may have influenced the decision. Although this was well above the BOE’s 2% target, it was below the forecast of 7%.

The BOE also noted signs of loosening in the labor market, stable wage growth, and weaker economic growth projected for the second half of the year. The U.K. economy contracted by 0.5% in July, with late mortgage payments reaching a seven-year high.

While BOE Governor Andrew Bailey mentioned that the committee would be monitoring the situation closely, many economists believe that this represents the peak rate for the bank.

Paul Dales, chief U.K. economist at Capital Economics, compared the BOE’s approach to that of the U.S. Federal Reserve, stating that the BOE “wants the markets to believe in the narrative of high rates for a prolonged period.” He added that the BOE doesn’t want the markets to expect rate cuts immediately after reaching the peak, as that would loosen financial conditions and undermine the bank’s efforts to control inflation.

While Capital Economics predicts rate cuts in late 2024, which will be more significant and faster than expected, HSBC economists don’t see any rate cuts in the next 15 months. Simon French, chief economist at Panmure Gordon, believes it is too early to predict the timing of the first interest rate cut due to the lack of clear indicators for easing.

Regional Outlook

The Swiss National Bank (SNB) decided to pause for the first time since March 2022, stating that the significant monetary policy tightening of recent quarters is countering remaining inflationary pressure.

Inflation in Switzerland reached 1.6% in August, within the national target range of 0-2%.

However, SNB Governor Thomas Jordan mentioned that “the war against inflation is not yet over” and emphasized that the central bank will continue monitoring inflationary pressures. This could potentially lead to further tightening in December.

Analysts described the SNB’s decision as a “hawkish pause” due to the cautious approach and absence of indications for rate cuts, despite Switzerland’s economic stagnation in the second quarter. The country is expected to record average growth of 1% for the year.

The SNB projects annual Swiss inflation to average 2.2% in 2023 and 2024, and 1.9% in 2025, assuming the policy rate remains at the current level of 1.75%.

In contrast, the European Central Bank (ECB) was seen as delivering a “dovish hike” on September 14 when it raised rates by 25 basis points and suggested that they may have reached a peak.

The ECB stated in a release that the key interest rates have reached levels that, when maintained for a sufficient duration, will contribute significantly to bringing inflation back to the target. The rates will be set at sufficiently restrictive levels for as long as needed. The ECB expects the eurozone to grow by just 0.7% this year and 1% next year, compared to nearly 2% growth forecasted for the U.S. in 2023.

Market pricing indicates a more negative economic outlook and an expectation that the central bank may be forced to make rate cuts by the middle of next year. Despite interest rate hikes generally boosting the value of a currency, the euro has fallen 1.7% against the U.S. dollar this month, marking its worst performance since February.

Inflation in Scandinavia

In northern Europe, Norway and Sweden opted for rate hikes and suggested that further tightening might be necessary.

However, there were indications of peak rates in these decisions as well. Ida Wolden Bache, governor of Norway’s Norges Bank, stated that there would likely be one additional rate hike, possibly in December. She added that a tight monetary stance would likely be necessary for some time.

Norway’s headline inflation rate was 4.8% in August, with core inflation at 6.3%. The Norges Bank’s forecast indicates a policy rate of 4.5% through 2024, up from the current 4.25%.

The Norges Bank, like other central banks, highlighted the uncertainty in its outlook, considering inflationary pressures and a weak krone as factors that could prompt further rate hikes. However, a more pronounced economic slowdown or rapid decline in inflation could lead to a lower rate.

Sweden’s Riksbank also stated that inflation is still too high and that further tightening of monetary policy is necessary. They raised their main rate to 4%. The Swedish krona has reached record lows against the euro in recent months. The Riksbank announced plans to hedge part of its foreign exchange reserves to address what they see as an undervaluation.

Sweden has experienced a severe housing market downturn, and the Riksbank projects a contraction of 0.8% in the national economy this year and 0.1% next year. Capital Economics predicts rate cuts before the middle of next year, sooner and faster than indicated by the Swedish central bank.

However, Carsten Brzeski from ING noted that the combination of inflationary pressures and weaker growth could lead to a different outcome, given the challenges faced by all central banks. He stated, “Central banks that prioritize their credibility and the long-term impact on inflation expectations, like the ECB and the Riksbank, may continue hiking rates.”

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