Interest rates: On track to be raised by central banks

The new inflationary shock from the war in Ukraine has made clear the prospect of interest rate hikes by the world's largest central banks, with the bar now set higher in terms of the tightening of monetary policy that will be required to return to a stable price level.

The determination to tackle inflation was evident last week on both sides of the Atlantic. The US central bank announced on Wednesday a half percentage point increase in its benchmark interest rate to 0.75% to 1%, while its chairman, Jerome Powell, announced a similar increase at the next two Fed meetings in mid-June and late July.

In other words, the US policy rate will be set at 2% in the summer, but will not be locked in there as new increases are expected from the autumn, with markets expecting it to exceed 3% by the end of 2022. Inflation in the US climbed to 8.5% in March and not just because of energy and food price increases. So-called structural inflation, which excludes the volatile prices of these products, rose 6.5% year-on-year, highlighting the severity of the problem.

At the same time, wages are being raised significantly in the US to compensate workers for the loss of real income caused by inflation. Therefore, the risk of spillover increases is high, and this explains the Fed's eagerness to tighten policy quickly to avoid entrenching expectations of long-term price increases, as in the 1970s and 1980s.

This will, on the other hand, have an impact on economic activity as the higher interest rates will reduce the demand for loans for housing or consumer durables and for investment. The question for many analysts is whether there will be a «soft landing» for the US economy, i.e. whether the policy to reduce inflation will slow down the growth of the economy without leading it into a recession. Powell appeared optimistic, saying there is a good chance of a soft landing. However, in the past the US economy has slipped into recession during periods of major monetary policy tightening.

A day after the Fed, the Bank of England announced its fourth consecutive base rate hike at 1%, also announcing that it will continue its restrictive policy. It also noted that there is a visible risk of inflation above 10% which would potentially drag the economy into a recession.

At the same time, last week it became clear that the European Central Bank intends to proceed with its first interest rate hike in more than ten years, barring an unlikely event in July. According to the Austrian central banker, Robert Holzmann, the quarter percentage point rate hike will probably be decided at the next ECB meeting on 9 June.

The acceleration of inflation in the Eurozone after the Russian invasion of Ukraine and its formation at 7.5% in April played a catalytic role in hastening the decision to raise interest rates. Even ECB officials - such as its chief economist Philip Lane - who have been advocating a loose monetary policy and predicting a return of inflation to the 2% target, now believe that a rate hike is now in order.

The main reason for this, cited by all the ECB officials who have made public statements recently, is to avoid the consolidation of inflationary expectations and thus a spiral of price and wage increases. Isabel Schnabel, who is a member of the ECB's Executive Board, also noted that with the war in Ukraine and the green transition, inflation is taking on more structural characteristics.

The ECB is also expected to make further rate hikes after the summer, as Snabel hinted, but overall it is expected to make less policy tightening than the Fed as both structural inflation is much lower -3.5% vs. 6.5% in the US - and wage increases are still limited in Europe.