As we know, interest rates are a key tool for central bank monetary policy, with higher rates intended to increase borrowing costs and slow the rate at which prices are rising, likewise lower interest rates seek to encourage borrowing and stimulate economic growth.
With inflation measures continually producing high readings, many market participants and financial commentators have called on central banks to take measures to slow down inflation.
But despite the world’s major central banks all experiencing similar levels of inflation - well above the 2% target - each one has taken a markedly different approach to attempting to restore price stability.
The Bank of England (BoE)
The BoE was the first of the three to make changes to its interest rate policy, raising rates to 0.25% in December 2021. Despite being the first to move, the path to the first-rate hike was not a smooth one for the BoE. Governor Andrew Bailey was accused of misleading investors after many believed that the comments made in October stating that the BoE “would have to act” were hinting to investors that rates would be increased at the November Monetary Policy Committee meeting.
This led to the term “unreliable boyfriend” being thrown towards Governor Bailey, a term that was often used to describe his predecessor Mark Carney who often hinted at rate hikes, but failed to deliver. The BoE continued a slow and steady hiking policy, with four further 0.25% raises at the next four meetings and decided to pick up the pace of rate increases as it became clear inflation was not subsiding with UK June CPI coming in at 9.4%.
The following meetings in August and September both delivered 0.50% rate increases, taking the BoE base rate to 2.25% despite UK inflation unexpectedly falling in August.
Interest rate expectations for the BoE increased rapidly towards the end of September, after the UK’s mini budget. The announcement of the largest tax cuts the UK has seen in over 50 years caused the pound to fall to an all-time low against the US dollar, due to expectations that the UK government will need to increase borrowing to fund the money lost by tax cuts. A statement by the BoE told investors it would "not hesitate to change interest rates by as much as needed to return inflation to the 2% target”, while there was no mention of an emergency meeting. Markets now anticipate a full 1% increase at the November meeting, and some market participants have even called for an emergency meeting.
The Federal Reserve (Fed)
Despite waiting until March 2022 to begin raising rates, the Fed took a much more aggressive approach to attempting to slow inflation. Chairman Jerome Powell has repeatedly told investors that the central bank will continue to raise rates until inflation begins to show clear signs of reducing, even if this causes economic pain for the US. After beginning with a 0.25% increase, the Fed followed this up with a 0.50% increase in May and two back-to-back 0.75% increases (the largest hikes since 1994) in June and July.
The September meeting delivered a third consecutive 0.75% increase, which brought the Fed Funds Rate to 3.25%. Hawkish commentary from chairman Powell has led markets to price in a fourth 0.75% increase in November, while official Fed projections show that rates are expected to be held above 4% throughout 2023 and no cuts are predicted until 2024. Keeping rates about 4% for over a year has caused serious concerns for market participants who fear that this policy could significantly harm the US economy.
The European Central Bank (ECB)
The ECB waited until July to begin raising rates despite Europe suffering the most as a result of Russia’s invasion of Ukraine, causing an energy crisis to spark.
This approach allowed the ECB more time in order to understand the key drivers of higher inflation and to see if these factors were transitory, however it also runs the risk of waiting too long to take action, consequently risking inflation rising even higher.
The bank’s first increase delivered an upside surprise as investors expected the bank to begin with a 0.25% hike but instead delivered a 0.50% increase and confirmed that further increases should be expected at future meetings. Eurozone inflation readings for July and August returned record high figures of 8.9% and 9.1% respectively, which contributed towards the ECB’s decision to raise rates a further 0.75% in its September meeting. With the ECB rate currently at 1.25%, further increases are expected to continue into 2023.
A slow and steady set of rate increases has been seen from the BoE, while the Fed has decided to move later with large increases and the ECB has taken more time to analyse data before acting.
As can be seen in the above chart, inflation in both the UK and the US has fallen in the most recent reading, with the US seeing two consecutive declines in inflation (falling from 9.1% to 8.5% and from 8.5% to 8.3%).
Many investors are optimistic that US inflation may now have peaked. Meanwhile, the outlook for UK inflation is less optimistic, despite inflation falling back below double figures. The UK Consumer Price Index (CPI) is still expected to rise higher towards the end of 2022, but due to the recent energy price cap, it’s estimated that inflation will now peak at 11% before beginning to slow once again in January. Eurozone inflation is still rising as August CPI was at 9.1% while current estimates for September predict inflation to be at 9.7%, showing no sign of slowing ahead of a winter that is expected to see further increases in energy costs.
Major central banks have now clearly shifted to a more aggressive stance, which seeks to bring inflation down at any cost. Although recent data appears to be showing early indications that these policies may be working, the potential for each region’s underlying economy to enter a slowdown grows with each additional interest rate increase.
It remains unclear which, if any, approach will be effective in bringing down inflation without causing a recession. What is clear is that central bankers are navigating unknown ground and are hoping to avoid the minefield which could present even greater challenges.