A Tale Of Three Central Banks – How The Fed, ECB, And BoE Differ On Monetary Tightening

At the start of February, the leading western central banks announced the latest round of interest rate adjustments. The Federal Reserve raised its benchmark rate by 0.25%, while the European Central Bank and the Bank of England decided on a more substantial 0.5% increase. The rates are now at a range of 4.5% to 4.75% in the US federal funds, 4% in the UK, and 3% in the ECB deposit rate. These rates are the highest rates seen since the 2008 financial crisis. Raising interest rates increases the cost of borrowing, putting a damper on consumer and business spending and ultimately reducing demand for goods and services, curbing inflation.

Despite close emulation of each other, a close analysis reveals a divergence in the monetary and fiscal outlook of the three central banks. The Fed’s 0.25% increase departs from previously larger increases in 2022, signalling a more relaxed approach to monetary tightening. Fed chair, Jay Powell, was quick to caution that further increases could still come; but the undertones of his announcement signalled a more positive outlook, stating he saw a path to reducing inflation to the 2% target without a “really significant economic decline.” Powell’s dovish tone diverged from that of ECB President, Christine Lagarde. She indicated that an almost-certain further 0.5% increase will follow in March, citing inflation as “far too high.” At the time of writing, eurozone inflation currently sits at 9.2% compared to 8.0% in the United States.

Following the announcements, US treasuries, and German and Italian bonds dropped yields. A yield is the interest an investor earns from holding a bond, expressed as a percentage of the bond’s price. When interest rates decrease, people want to buy bonds with higher yields, making their prices go up and their yields go down. The drop in yields, therefore, reflects the market sentiment that interest rates will soon peak. Equities also surged, with US stocks closing at their highest since the summer of 2022.

However, equities were quick to correct following the release of US employment data, with the S&P 500 falling 1.1% as US stocks recorded their largest decline in two months. The data, which shows US unemployment at 3.4% – its lowest in 53 years – was a surprise to many as it defied expectations that monetary tightening had caused a slowdown in job creation. The US Bureau of Labour Statistics further reported that payrolls in January rose by 517,000, exceeding the much smaller forecast of 185,000. High employment combined with high-interest rates puts upward pressure on wages, leading to higher prices for goods and services and higher inflation; this can necessitate rate hikes to contain inflationary pressures. It was therefore not surprising that Jay Powell, speaking before the Economic Club of Washington after the data was made public, cautioned that the Federal Reserve may need to raise interest rates at a quicker pace than is priced in by financial markets.

The Bank of England appears to be the most optimistic about inflation. Despite raising rates by 50 basis points, it dropped language that it would continue to act “forcefully” to combat inflation, which it now forecasts will be well below its 2% target next year. This jubilant forecast has led some to call into question why it raised rates at all, and indeed two of the Bank’s rate-setters favoured no increase at all, marking an end to Threadneedle Street’s unanimity for rate hikes. Governor Andrew Bailey stoked positive sentiment further during a select committee hearing, where he stated that “inflation is going to fall very rapidly.” Markets are reacting positively: yields on UK gilts have dropped and the FTSE 100 reached an all-time high; five-year fixed mortgage rates are expected to fall below 4%.

While central banks emphasize that there is still a long way to go, a brighter outlook is beginning to emerge from the fray.

By

Joshua Troup