Here we set out our views on the rate-hiking cycles in major developed markets (DM). Most DM central banks are in the process of reducing accommodation, but the need for an outright restrictive monetary stance is not clear as of yet. We distinguish between the peak and the terminal (equilibrium) policy rate and argue that while the former could end up above the latter temporarily, the evidence isn’t clear cut at this stage and that the path isn’t necessarily the same across major jurisdictions. Overall, inflationary pressures are most acute in the US and somewhat more gradual but potentially longer-lasting in Europe. On the other hand, equilibrium real rates might not be all that different compared to pre-Covid times.
The terminal nominal interest rate is composed of the real policy interest rate in equilibrium, i.e., consistent with output at potential and stable inflation, plus (equilibrium) inflation. The academic literature clusters estimates of this equilibrium or neutral real rate in major developed markets close together, at around zero (or slightly in negative territory).1 Most models agree that real equilibrium interest rates have moved lower due to demographics and lower trend growth, factors that are similar across advanced economies, and there is no conclusive evidence that Covid has interrupted this trend, let alone reversed it. For simplicity, this implies a terminal nominal interest rate around 2.0%-2.5%, assuming that inflation is close to target in equilibrium. This is reflected, for example, in the long run projection for the fed funds rate at 2.4%, contained in the Federal Open Market Committee’s (FOMC) Summary of Economic Projections (SEP). For other central banks, the real equilibrium rate might be slightly negative, resulting in a somewhat lower terminal nominal interest rate.
The equilibrium rate has, however, only an indirect bearing on the monetary policy stance, which is constantly responding to “shocks” and therefore never quite in equilibrium. In the current context, the hiking cycle in advanced economies is responding to a more inflationary environment and the extent of the hiking cycle—in other words, the peak rate—depends on expectations regarding the nature of inflationary pressures, the course of the economy and the reaction function of the central bank.
First, inflationary pressures around the world over the last 12 months or so have been significant and display a number of common drivers, including fiscal stimulus, energy inflation and supply-chain constraints. The relative importance of those drivers has been quite varied across jurisdictions, however. In the US, a large part of headline inflation is concentrated in goods, driven by substantial fiscal transfers to households combined with supply-side disruptions. Going forward, supply-side disruptions should fade over time and demand will slow as household savings drop. In continental Europe on the other hand, energy inflation (both household and transport fuels) still constitutes more than half of overall inflation. As energy prices cannot keep growing forever, that part of headline inflation will, sooner or later, slow substantially. The UK situation displays elements of both the US and continental Europe.
Second, all three economic blocs share one major concern: a weakening of real disposable income as a consequence of high inflation and (for now) more moderate fiscal support after a couple of years of extraordinary measures. This alone already implies a rapid sequential slowdown in the second half of this year and into 2023. While the economic slowdown should reduce pressures on wages and underlying inflation, it is a priori unclear whether the same will also play out for headline inflation but the likelihood certainly increases as long as inflation expectations remain anchored.
Most traditional measures of medium- and longer-term inflation expectations have not, so far, given major cause for concern but might be “myopic,” i.e., adjusting to extended recent periods of high realized inflation.
Finally, and maybe somewhat less importantly at the current juncture, central bank remits in the US and the eurozone have changed on the margin. Flexible average inflation targeting (by the US Fed) and a truly symmetric target (for the ECB) may, over the medium term, lead to the same outcome as under the previous frameworks, ideally a point landing on the inflation target. Over the more immediate horizon, however, they may have introduced a lag in reaction time and therefore an upward bias to realized inflation compared to the time before those framework changes were implemented. Everything else equal, this would imply a higher peak in nominal rates before settling back into (a lower) equilibrium.
Market Pricing and Our Take
At this point, the market is pricing, for the US, a rather quick rebound of the fed funds rate to a peak level moderately above the terminal level. The overshoot is expected to be short, however—markets see the fed funds rate falling back to the terminal rate in 2024. This is quite different in Europe. For the eurozone, the market currently expects a much slower increase in the policy rate and a peak barely above 1% in about two years’ time—below the ECB’s terminal rate even after adjusting for a lower equilibrium rate. For the Bank of England, the market currently expects the policy rate to rise quickly to around 2.5% and remain there for a year before falling back in 2024.
We believe that the rate-hiking cycle currently priced by the market in the US is somewhat aggressive in the near term given our expectation for a significant economic slowdown, but we can see the Fed achieving a broadly neutral stance later this year or early next year. In the eurozone, structural growth drivers (especially longer-term fiscal support) are somewhat less cyclical than in the US; we don’t see as much downside risk for the ECB’s rate path given that much less is priced in. Instead, we can also imagine a longer hiking cycle into restrictive territory if the near-term risks fade away. That said, those risks are quite substantial and deteriorating energy security could lead to a European recession, with significant impact on the ECB’s hiking cycle. Finally, the Bank of England is more advanced by a quarter or two compared to its peers and it has already tapered the hawkish narrative as the first signs of demand weakness have arisen. In many ways, we believe that the UK will serve as a leading example: slowing demand based on a drop in real disposable income is not a unique characteristic of the UK—other major economies are just getting there a bit more slowly.
1. See, for example, ECB Occasional Paper 217 by Brand, Bielecki and Penalver (eds., 2018)