Decoding Central Banks: How Fed, ECB, and BOE Rate Hikes Impact Inflation and Markets

The financial world is watching closely as central banks navigate the complex dance of inflation and economic growth. Recently, we’ve seen key players like the Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of England (BOE) making significant moves to address rising prices. Let’s break down what’s happening and what it means for you.

What’s the Inflation Situation? A Quick CPI Check

Good news first! On December 13th, the Consumer Price Index (CPI) showed a further drop to 7.1%. This was welcome news for markets, triggering a rally in equities and a dip in the US dollar and treasury yields. Think of it as a collective sigh of relief – but is it time to celebrate just yet?

This positive CPI figure is driven by:

• Falling Core Goods Prices: A 0.5% decrease, indicating some easing in the cost of tangible goods.
• Energy Price Relief: A significant 1.6% drop, bringing down overall inflation.

It’s worth noting that core goods inflation has dramatically decreased from over 12% in February to below 4%. That’s a considerable shift! However, before we declare victory against inflation, let’s look at the bigger picture.

Service Inflation: The Sticky Challenge

While goods and energy prices are showing signs of cooling, service inflation is proving to be a tougher nut to crack. Excluding energy, service inflation actually rose to 6.8%. Why is this important?

Services make up a large chunk of what we spend money on – think healthcare, housing, transportation, and entertainment. The strength of the US job market is a key factor keeping service inflation elevated. A strong job market means more people with disposable income, potentially driving up demand and prices for services. However, the big question is: will this job market strength persist into 2023?

The Fed’s Firm Stance: ‘Ongoing’ Rate Hikes

On December 14th, Federal Reserve Chairman Jerome Powell announced an expected 50 basis points (bps) interest rate hike. This brings the new federal funds rate target to 4.25%-4.5%. So, what’s the Fed’s message?

• ‘Ongoing’ Rate Hikes: Powell reiterated that further rate increases are likely.
• ‘Staying the Course’: The Fed is committed to tackling inflation until the job is done, signaling a persistent approach.
• Slow Inflation Decline: The Fed anticipates a gradual decrease in inflation due to the still-tight labor market.

Despite some price drops in housing and goods, a significant 55% of core CPI components are still increasing rapidly. This suggests that underlying inflationary pressures remain, even if headline numbers are showing some improvement.

Market vs. Fed: A Difference in Expectations

Interestingly, the market’s expectations for future interest rates differ from the Fed’s projections. Currently, the market anticipates the fed funds rate to peak at 4.8% in May 2023, and then decrease to 4.5% by December 2023. This implies the market believes the Fed will need to cut rates later in the year, possibly due to economic slowdown.

However, the Fed’s own projections, visualized in the ‘DOT plot’, tell a different story. Each ‘dot’ represents a Fed policymaker’s view on the future federal funds rate. The latest DOT plot reveals:

• Higher Fed Projections: The Fed’s projected funds rate for the end of 2023 has been revised upwards to 5.1%, from 4.6%.
• Hawkish Stance: Seven Fed officials anticipate rates above 5.1%, and ten predict rates above 5%.

This divergence between market expectations and Fed projections highlights uncertainty about the future path of interest rates and the economy.

Global Rate Hikes: BOE and ECB Join the Fight

The Fed isn’t alone in its battle against inflation. Other major central banks are also taking action:

Bank of England (BOE)

On December 15th, the Bank of England also raised its bank rate by 50 bps, bringing it to 3.5%. This marks the ninth consecutive rate hike by the BOE. There’s a glimmer of hope in the UK, as inflation may have peaked. Inflation fell from 11.1% to 10.7%, and the core rate also decreased from 6.5% to 6.3%. This outperformed market expectations, suggesting a potential turning point.

European Central Bank (ECB)

The ECB followed suit, raising interest rates from 1.5% to 2%. Beyond rate hikes, the ECB also announced plans to reduce its balance sheet. This is another tool to tighten monetary policy by decreasing the amount of money circulating in the economy.

What Does This Mean for You?

These coordinated rate hikes from major central banks are aimed at cooling down inflation. Higher interest rates make borrowing more expensive, which can dampen demand and slow down economic activity. The intended effect is to bring inflation back to target levels, but it also carries the risk of slowing down the economy too much.

Key Takeaways:

• Inflation is showing signs of easing, but service inflation remains a concern.
• Central banks are committed to further rate hikes to combat inflation.
• There’s a disconnect between market expectations and central bank projections for future interest rates, creating uncertainty.
• Global central banks are acting in concert to address inflation.

Looking Ahead

The coming months will be crucial. We’ll be watching closely to see if inflation continues to moderate, how the labor market evolves, and how these rate hikes impact economic growth. The path forward is uncertain, but one thing is clear: central banks are determined to tame inflation, and their actions will continue to shape the global economic landscape.

Here’s a look at the Fed’s, ECB’s, and BOE’s CPI and rate hikes.

A further drop in CPI to 7.1% on December 13 was met by an expected rally in equities and a drop in the US dollar and treasury yields. Powell raised interest rates by 50 basis points on December 14 to a new federal funds rate target of 4.25%-4.5%.

Headline inflation fell from 7.7% to 7.1%, offset by a 0.5% drop in core goods prices and a 1.6% drop in energy prices.

Core goods inflation has remained below 4% since peaking at more than 12% in February. However, excluding energy, service inflation rose to 6.8%. Services inflation will remain elevated as the job market in the United States remains strong; however, this could change in 2023.

The fed raised rates by an expected 50bps to set the new fed funds target of 4.25%-4.5%, and the tone from Powell remains unchanged “ongoing” rate hikes and “we will stay the course until the job is done”. Powell anticipates that inflation will continue to fall slowly as the labor market remains tight. Despite falling house and goods prices, 55% of core CPI continues to rise rapidly.

The market is still at odds with the Fed over futures fed funds rates. The market expects the fed funds rate to peak at 4.8% in May 2023, then fall to 4.5% by December 2023.

Each dot on the DOT plot, which depicts federal funds rate projections, represents the viewpoint of a Fed policymaker. The Fed’s projected funds rate at the end of 2023 is higher than the market’s, revised from 4.6% to 5.1%; seven Fed officials predict a rate above 5.1% and ten above 5%.

On December 15, the Bank of England raised the bank rate by 50 basis points to 3.5%. The BOE raised interest rates for the ninth time in a row. Furthermore, inflation in the United Kingdom may have peaked, as inflation expectations outperformed market expectations, and inflation fell from 11.1% to 10.7%, with the core rate falling to 6.3% from 6.5%.

Furthermore, the ECB raised interest rates from 1.5% to 2% and announced plans to reduce its balance sheet.