In race back to neutral the biggest traps lie in the euro-zone - Capital Economics
The Chief Economist's Note

In race back to neutral the biggest traps lie in the euro-zone

The Federal Reserve dominated markets last week, briefing a super-sized hike in interest rates to the press on Monday and duly delivering it at the conclusion of Wednesday’s FOMC meeting. It was the most prominent sign yet of the markedly hawkish shift in recent weeks by global central banks. Policymakers from Australia to India have stepped up the pace of monetary tightening since the start of this month, the European Central Bank has outlined plans for a relatively aggressive lift-off in rates starting in July, and even at the Bank of England, three members of the MPC voted for a larger 50bps increase in interest rates last week, despite data showing a surprise contraction in the UK economy in April.

This sudden shift lies behind the latest turmoil in financial markets, which has in turn fuelled breathless commentary by analysts and in the financial press about new global economic and financial crises. At such times, it pays to step back and consider the bigger picture. A couple of points are worth stressing.

First, given that central banks are starting from an ultra-accommodative position, and that economies and inflation are running hot, it makes sense for them to front-load tightening. I argued back in February that the priority for central banks should be to return policy to a more neutral setting as soon as possible. Since then, the war in Ukraine has given an additional impulse to inflation, making it even more important that policymakers get back on the front foot. 

Accordingly, we should expect more hawkish surprises from central banks over the next few months. This will lead to more collateral damage in financial markets, and hit vulnerable emerging markets like Turkey, but central banks will view this as a price that has to be paid for regaining the initiative on inflation. 

Second, it’s important to distinguish between the speed at which interest rates are increased and the level to which they’re ultimately raised. The extent of monetary tightening that will be required from central banks will depend on the balance between aggregate demand and each economy’s ability to supply goods and services. The fact that most economies now seem to be running hot suggests that most central banks will to some extent need to bear down on demand. But policymakers might also get a helping hand from an improvement in the supply-side of economies.

In particular, labour markets are still feeling the effects of the pandemic. This is manifesting itself in different ways: in the US, participation rates are low relative to pre-COVID norms, in the euro-zone hours worked have yet to fully recover, and in the UK, long-term sick rates have risen, pushing workers out of the labour market. There is scope for labour supply to improve in all three economies as pandemic-era frictions ease and, while this won’t help the inflation picture in the very near term, it could make central banks’ lives easier over the next year or so. The uncertainty around supply-side dynamics complicates the judgement as to how far (rather than how fast) interest rates will need to rise. 

Irrespective of this, the peak in interest rates will differ between countries. In the US, excessively strong demand means that the Fed will need to push policy rates some way above neutral (we’ve pencilled in the Fed Funds rate to peak at 3.75-4.00%). In the UK, we think that the Bank of England will need to raise rates further than it expects to quell price pressures caused by a hit to supply (we’ve pencilled in a peak in Bank Rate of 3%). 

But interest rates in the euro-zone are likely to peak at a lower level. For a start, aggregate demand isn’t as hot in the euro-zone as it is in the US. This is partly because pandemic-era stimulus was smaller but also because, unlike in the US, the euro-zone has experienced a substantial deterioration in its terms of trade as global commodity prices have surged. Moreover, neutral interest rates are probably lower in the euro-zone than they are in the US. 

But concerns about economies in the euro-zone’s vulnerable periphery will also complicate the ECB’s policy response. The fact that the Governing Council was forced to hold an emergency meeting last week was an implicit acknowledgement that it did not adequately address the problem of “fragmentation risk” at its scheduled policy meeting earlier this month. 

In the event, the steps announced at the conclusion of the emergency meeting were more of a sticking plaster than a permanent solution. That’s to be expected given the complexities of formulating policy at short notice. But the fact that policymakers did not adequately consider the problem at their scheduled meeting and were then forced by the bond market into an emergency session several days later is ominous given the unique challenges facing the ECB. 

Unlike other central banks, the ECB needs to raise short-term interest rates and deliver tighter financial conditions to reduce inflationary pressures, while at the same time ensuring that bond yields in highly-indebted member states do not rise excessively. Furthermore, all policy decisions must be agreed by the 25 members of the Governing Council, with competing views on the extent to which the central bank should backstop bond markets. It’s possible that the Bank will get the balance right, but it won’t be easy.

That’s why, amid this flurry of global central bank activity, it pays to watch what’s happening with the ECB: as the race to normalise policy heats up, the biggest traps lie in the euro-zone.

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