Markets are currently uncertain about the future of interest rate hikes in both the US and eurozone following the recent policy meetings of the Federal Reserve (Fed) and the European Central Bank (ECB). Both central banks raised interest rates by 25 basis points, but there is speculation that the rate hiking cycles may be nearing an end.
US futures contracts indicate that the Fed rates will only rise by an additional 9 basis points for the remainder of the year, reaching 5.42%. This suggests that there will be no further increase in official rates and that the range for the fed funds rate will remain between 5.25% and 5.50%. On the other hand, eurozone rates are expected to be around 15 basis points higher by the end of the year, indicating that investors are hedging their bets on a possible 25 basis point hike in the fourth quarter.
It is worth noting that both the Fed and the ECB have stopped providing guidance on the near-term path for interest rates. Instead, they have adopted a data-dependent approach to future policy decisions, allowing them to keep their options open regarding further rate hikes.
In the US, there is optimism in the markets that the Fed’s job of tightening rates is complete. However, the Fed meeting statement acknowledged that inflation remains elevated. Fed chair Jerome Powell also mentioned that bringing inflation back down to its 2% target may require a period of below-trend growth and some softening in labor market conditions. Despite this, the US economy has experienced above-trend growth in the first half of 2023, with GDP growing by 2% and 2.4% annualized in the opening two quarters. Unless there is a significant softening of these data in the second half of the year, the Fed may decide to hike rates again, even if inflation continues to decrease. The Fed’s own interest rate projections indicate that they expect rates to reach a range of 5.50% to 5.75% by the end of the year, implying one more rate hike.
It is surprising, therefore, that markets are assigning such a low probability to the likelihood of another rate hike in the US.
Meanwhile, markets are starting to price in a further 25 basis point hike from the ECB, despite the weakness in economic activity since last autumn. The ECB’s main focus is likely to remain on underlying inflation, as the core Harmonized Index of Consumer Prices (HICP) rate remains high at around 5.5%, well above the 2% target. The ECB is finding some comfort in the fact that rate hikes are tightening financial conditions and dampening demand, which should help bring inflation back down to target. However, the ECB will need to see evidence of this in inflation data over the next few months, including wages and labor costs, in order to put a hold on further rate hikes. The ECB’s upcoming staff economic projections in September will also play a role in determining future policy decisions, particularly if inflation forecasts are revised lower.
Given these factors, it is not surprising that the ECB has kept its options open regarding raising rates again.
Oliver Mangan, chief economist with AIB, provides this analysis.