Wakey Wakey

This week was a huge one for central banks, as they seemed to realize that maybe, just maybe, they hit snooze on interest rate hikes for a little too long…

 

🕰 Recap

  • Data out a couple of Fridays ago showed consumer prices in the US rose by more than expected in May.
  • That might be why the US Federal Reserve (the Fed) raised interest rates by three-quarters of a percentage point on Wednesday – its biggest hike since 1994.
  • A day later, the Bank of England upped its key interest rate by a quarter-point for the fifth time in a row, bringing it to a 13-year high.

 

✍️ Connecting The Dots

The Fed was full of surprises on Wednesday: not only did the central bank deliver the biggest rate increase since 1994, with a 0.75 percentage point rise, it also signaled that another hike of that size was possible next month, as part of its plan to control soaring inflation. This, even after Fed chair Powell dismissed the idea of “jumbo” rate hikes just last month. So it’s hardly surprising that it’s been slammed by critics for not anticipating the fastest price gains in four decades, and then for being too slow to respond.

Still, Powell’s hands were probably tied after two reports a week ago showed an unexpected jump in consumer prices in May, as well as a sharp rise in inflation expectations. That led the Fed to make some new projections, in which it forecast interest rates would rise even more this year to 3.4% by December – a big upgrade from the 1.9% it projected in March. That suggests the central bank will implement at least one more three-quarter-point increase this year, probably throwing in a couple of half-point adjustments before moderating to a more typical level of quarter-point increases.

The Fed also acknowledged the impact this would have on economic growth, which it now thinks will slow to 1.7% this year rather than the 2.8% expansion it projected in March. That’s an idea the UK might also want to get used to: just a day after the Fed’s decision, the Bank of England hiked rates for the fifth time in a row and hinted that it may join the growing global trend of bigger hikes if inflation continues to climb.

 

🥡 Takeaways

1. Recession is getting harder to avoid. 

One of the most notable changes in the Fed’s latest policy statement from the last was the removal of the phrase, “the committee expects inflation to return to its 2% objective”. That suggests the central bank sees price pressures persisting over the medium term, making it more likely that it’ll get even more aggressive with its rate hiking campaign. But that will probably come at the expense of economic growth, with an increasing number of investment bank analysts and economists now forecasting a US recession next year.

2. The European Central Bank (ECB) has its fair share of issues too.

The ECB is set to raise interest rates for the first time in 11 years next month to deal with its own inflation problem. But expectations of higher rates have created a new problem: they’ve sent borrowing costs surging in the eurozone’s weaker economies, reviving fears about a potential repeat of the damaging debt crises in 2012 and 2014 that nearly tore the eurozone apart. So the ECB convened an emergency meeting on Wednesday, aiming to speed up work on a policy tool that should narrow the cost-of-borrowing gap between more stable countries like Germany and vulnerable member states like Italy.

 

🎯 Also On Our Radar

The spread on US junk bonds – that is, the extra yield they offer compared to government bonds to compensate for their extra risk – topped 5% for the first time since November 2020 this week. This is an important psychological barrier, and breaching it is a telling sign: it shows investors are increasingly worried about more defaults. It’ll also make borrowing more expensive for companies that need it the most.

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