By Arif Husain, CIO fixed income at T. Rowe Price
Could we be entering the zone of a global monetary policy mistake? Recent hawkish stances taken by some major developed market central banks make this a valid question.
There is now a meaningful risk these central banks could overtighten in a quest to quell inflation and help push the global economy into recession, as well as induce a financial market recession. China’s central bank, on the other hand, may be making a different type of policy error by not easing policy enough to support the country’s economy.
ECB lacks track record in inflation forecasting
The European Central Bank (ECB) provided what is probably the most obvious recent example of an extremely hawkish position from a major central bank. At its June meeting, the ECB raised rates by 25bps and President Christine Lagarde said to expect another hike in July. Most significantly, it surprised the markets by raising its 2025 inflation forecast – consensus expectations had been for a decrease in the inflation outlook, so the increase sent a strong hawkish signal.
As a result of this revised forecast for higher inflation, we think the ECB could even hike again at its next meeting in September. However, like most central banks, the ECB does not have a strong track record for accurately predicting inflation, so there is a distinct possibility inflation will be lower than forecast – resulting in overtightening of monetary policy.
Muscular Fed could hike rates too much
Although the Federal Reserve (Fed) kept rates steady at its June policy meeting following 10 consecutive increases totalling 500bps, policymakers expect to raise rates twice more in 2023. Fed Chair Jerome Powell underscored the Fed’s seemingly muscular approach to taming inflation by declaring rate cuts are unlikely for a couple of years. This may have been part of an effort to convince markets not to price in cuts this year, and it worked – futures contracts post-Fed meeting showed rate decreases starting in early 2024.
The Fed indicated it will take into account the cumulative effects of policy tightening when determining how much more to raise rates, signalling it is likely to take more time between hikes. But will this prove adequate to forestall a recession? The stickiness of core US inflation and the Fed’s focus on returning inflation to its 2% target could easily lead the Fed to move rates too high and be slow to cut when the economy enters recession.
BoE fell behind the curve on inflation
The Bank of England (BoE) seemed to be on the right side of change when it became one of the first major developed market central banks to raise rates following the 2020 economic bounce back from the pandemic-induced recession. However, it then adopted a ‘do not worry, inflation will come down’ stance through much of 2022. As a result, it fell behind the curve in inflation fighting, and headline UK consumer price inflation spiked to well over 10%. Now public sector workers in the UK are demanding massive pay increases, raising fears a wage-price spiral may be setting in.
In response, the BoE surprised markets with a larger-than-expected 50bps hike to 5% at its June meeting, leading to expectations its terminal rate for this cycle will be 6%. Mortgage rates could reach 8%, which would crush consumer spending in a country where fixed-rate mortgages are rare. Pressured by this environment of still-hot inflation, the BoE could easily raise rates to a level that would push the economy into recession.
Post Covid China is plainly faltering
Of course, central bank policy errors can take different forms. Instead of raising rates too far, China may not be cutting aggressively enough to sustain economic growth. The People’s Bank of China (PBOC) lowered its policy rate on one-year medium-term lending facility loans by a paltry 10bps in June, its first cut since August 2022. While it followed with minor cuts on the one and five-year loan prime rates, China’s economy is plainly faltering after a post-zero‑Covid‑policy bump, and it could have difficulty achieving even the relatively modest 5% annual growth target that the government set for 2023.
But China is an anomaly in a world of many developed market central banks striving to contain inflation. By extending hiking cycles amid sticky inflation, central banks could be creating more economic pain down the line. In contrast, some emerging market central banks are successfully bringing inflation down after moving more quickly and meaningfully to raise rates. The central banks of countries such as Brazil are now considering rate cuts, leading us to question whether the local currency bonds of these nations are priced with an excessive risk premium – and whether developed market sovereigns have enough risk premium.
