Central Banks keep hiking to tame the inflation beast
By the OFX team | 5 May 2023 | 5 minute read
Three central banks, in the space of a week, raised interest rates citing inflation as their core concern.
- On May 3rd, the US Federal Reserve raised rates for the 10th consecutive month by 0.25% to a 16-year high of 5%
- The following day, the European Central Bank (ECB) increased its key rate by a quarter percentage point, to 3.25%, a near 15-year high
- Those announcements followed a surprise rate hike by the Reserve Bank of Australia (RBA) to 3.85%, on May 3 (Australian time)
In the case of the US Federal Reserve, the language from its chair, Jerome Powell suggested this rate rise might be the last. The Fed dropped a key phrase – “additional increases might be appropriate” – that appeared in the March statement.
“We feel like we’re getting closer or maybe even there,” Powell said in relation to rate rises.1
The ECB and the RBA struck more cautious, or hawkish tones. While the ECB slowed down the rate of increase, in the press conference following the hike, ECB President Christine Lagarde said the decision was “based on the understanding that we have more ground to cover and we are not pausing.”
“We all concluded that the inflation outlook is too high and has been so for too long,” she said, explaining that some officials advocated a larger half-point rate increase.2
The RBA’s governor, Phillip Lowe, noted “inflation in Australia has passed its peak, but at 7 per cent it is still too high and it will be some time yet before it is back in the target range,” in his post-meeting statement.
The euro and the Aussie dollar both shot up against the greenback off the back of the rate hikes, with traders digesting the likelihood that as the Federal Reserve potentially stops hiking, other currencies will start offering favourable investment returns.
Is inflation starting to moderate?
After months of rate hikes, it looks like the US Federal Reserve is finally getting on top of inflation.
The so-called core Personal Consumption Expenditure (PCE) price index rose by just 0.1% for the month of March, making it a rise of 4.2% over the year, well down from the 5.1% rise recorded in February. At its peak, it hit 7% in June last year.3
Food and energy — two of the major areas hit by COVID-19 supply issues and the invasion of Ukraine — saw the biggest declines. Food prices decreased 0.2 % and energy prices decreased 3.7 %.4
That’s a positive sign, but it’s not the full story. As volatile components of the inflation index, food and energy are stripped out, meaning the US Federal Reserve focuses instead on “core” PCE. That index rose by 0.3% to be up 4.6% over the year, still higher than the Fed’s inflation target of 2%.
But the figure that would worry the Federal Reserve is the rise in wages. Wages and salaries for private-sector U.S. workers were up 5.1 % in March from a year earlier, and up 1.2 % from December.5 That pushed the employment cost index, another key inflation measure for the Fed, to 1.2% for the first quarter, higher than expected. While the numbers are certainly high, they may not be as inflationary as they might be. Digging deeper into the Bureau of Labor statistics data and the largest wage rises — 6% — occurred in the traditionally lower paid service sectors, and economists suggest that rising wages haven’t been a key driver of recent inflation.6
Eurozone inflation remains sticky but some positive signs
The annual inflation rate in the Euro Area was 6.9% in March 2023, down for a fifth consecutive month from last October’s record high of 10.6%. But it is still well above the European Central Bank’s target of 2.0%.
The good news is energy prices dropped 0.9% in March, the first drop in two years, while non-energy industrial goods inflation also moderated in February. The bad news is core inflation hit a fresh record high of 5.7%, with services inflation continuing to rise (to 5.1% vs 4.8%).7 Food inflation looks to have peaked.8
Can central banks land a slowdown without a recession?
U.S. gross domestic product slowed to 1.1% in the first quarter of the year, down from 2.6% in the previous quarter, suggesting that rate rises are starting to bite. Consumer spending, which accounts for more than two-thirds of U.S. economic activity, was flat in March and February’s data was revised down from 0.2% growth to a 0.1% contraction. That was driven by a decline in consumers buying goods such as motor vehicles9, a clear sign consumers are putting off big ticket purchases. They also seem more worried about rainy days, with personal savings growing at 5.1% over the year10, the highest rate in almost 18 months.
Rate rises haven’t quite cooled the employment market however, with employers adding nearly 345,000 jobs a month on average in the first quarter, although job vacancies have declined. This robust demand for workers, will still be driving wage inflation., as highlighted earlier.11
Powell did suggest there might be a mild recession with the wild card in that scenario the potential for continuing failures of regional banks.
In the eurozone, wage growth continues to be stubbornly high despite the fact economies in the region appear to be crimped by rising rates, with firms in the services sector complaining of labour shortages, suggesting that more wage pressure could come this summer.
The eurozone economy did not grow at all in the fourth quarter and only by 0.1% in the first of the year. Of concern was household consumption, in the fourth quarter it recorded the largest decline since the eurozone’s founding in 1999.12
A credit crunch is of concern in the eurozone as well, following on from the collapse of Credit Suisse, and appetite from borrowers is also down — eurozone banking data showed the biggest drop in demand for loans in over a decade.13
The challenge all central banks are facing is whether the moderations in inflation are reflective of earlier rate hikes, or whether this week’s further tightening of screws will crush economies to a greater extent. It’s a delicate balance that has economists divided.
What that means for currencies
Currency markets will be keeping a close watch on economic data going forward. Further signs of slowdown balanced against inflation signals will influence which currencies move most, and those currencies, like the euro where rate hikes continue, will be favoured.
A steep recession, if that lag effect is greater than central bankers predicted, will favour the US dollar. Its status as a safe haven currency in times of trouble might reverse the greenback’s current downward trajectory.