Despite Fed pause, interest rates in the US and Europe are likely to stay higher for longer
- In their latest moves, the ECB raised rates while the Fed chose to pause, but both central banks remain focused on taming inflation
- A US recession could still be triggered by a too-aggressive Fed or fresh regional bank turmoil
As economies reopened post Covid-19, the main responsibility of the US Federal Reserve and European Central Bank (ECB) was to be laser-focused on cooling inflation against the strong economic backdrop. In the past year, both central banks have been driving like racing cars, with the Fed revving up interest rates by 5 percentage points since March last year, while the ECB, having started its engine a bit later, in July 2022, has raised its rates by about 4 percentage points.
The racetrack this year has become more challenging. Both central banks need to balance their monetary policies between still-sticky inflation, a greater risk of recession and financial-sector shocks.
But further tightening may be too aggressive given that US headline inflation is coming down and there are growing signs the economy is decelerating. In particular, this month’s inflation rate should soften further compared to the high base last year, driven by slowing rent rises and used car prices. Thus, a policy mistake, leading to a deeper-than-expected recession, could be a key risk.
But, before diving into the debate between a deeper-than-expected recession and a soft landing, one key investor question is: are we really going to enter a recession or are we already in one, without us noticing?
Let’s get the definition right for starters. A recession is commonly understood as two consecutive quarters of decline in real gross domestic product – but the authoritative Business Cycle Dating Committee of the National Bureau of Economic Research has its own definition.
Recession, as defined by the committee, is a significant decline in economic activity, spread across the country, lasting more than a few months and manifesting in drops in real personal income (not including transfers), employment as measured in both the household and payroll surveys, real consumer spending, real retail and wholesale sales, as well as industrial production.
Similar to the Fed, the ECB has remained hawkish and raised rates by a quarter of a percentage point, taking the policy rate to 3.5 per cent last week, as core inflation remained stickier than expected. According to ECB president Christine Lagarde, the central bank is very likely to raise the rate again next month, although the policy statement only signalled the direction without committing to specific meetings or a particular terminal rate.
The ECB policy rate could hit 4 per cent. In contrast with the US, European inflation has yet to show convincing signs of coming down. The central bank’s increased focus on the strong labour market is another hawkish signal that the tightening cycle is likely to continue. As the dilemma between growth and inflation is less profound for the ECB, a pause may come later for Europe: the ECB may not be taking its foot off the accelerator any time soon.
Even though the two central banks took different actions in their most recent meetings, inflation control remains the priority, with the interest rate rise cycle likely to end sooner in the US than in Europe. But, even with the US pause last week, rates are likely to stay higher for longer. Expect this high-speed action film to go on, at least until the end of this year.
Marcella Chow is a global market strategist at J.P. Morgan Asset Management