MondayFounder

The anticipated interest rate cuts by major central banks toward the end of 2023 have been factored into the market for quite some time. However, economists are now reevaluating their expectations due to persistent core inflation, tight labor markets, and the unexpected strength of the global economy.

The Federal Reserve, considering the robust U.S. jobs figures and gross domestic product data, faces a crucial risk of easing its monetary policy prematurely. The resilience of the economy and the ongoing tightness in the labor market could lead to upward pressure on wages and inflation, potentially causing entrenched inflation dynamics.

While the headline U.S. consumer price index has significantly cooled off since its peak of over 9% in June 2022, dropping to 4.9% in April, it still remains well above the Fed’s target of 2%. Of particular concern is the core CPI, which excludes volatile food and energy prices and rose by 5.5% annually in April.

Chairman Jerome Powell, following the Fed’s tenth interest rate increase since March 2022, hinted at a likely pause in the rate-hiking cycle during the Federal Open Market Committee’s June meeting. However, minutes from the previous meeting revealed differing views among committee members, with some advocating for additional rate hikes while others predicted a growth slowdown that would obviate the need for further tightening.

Federal Reserve officials, including St. Louis Fed President James Bullard and Minneapolis Fed President Neel Kashkari, have recently suggested that stubborn core inflation might necessitate a prolonged period of tighter monetary policy. This has led to speculation that more rate hikes may be implemented later in the year.

New data released on Friday indicated that the personal consumption expenditures price index, the Fed’s preferred gauge of inflation, rose by 4.7% year-on-year in April. This further reinforced the persistence of inflationary pressures and fueled expectations of longer-lasting higher interest rates.

Several economists have cautioned that the U.S. central bank might be compelled to adopt a more aggressive monetary policy stance to address underlying economic dynamics that resist normalization.

According to CME Group’s FedWatch tool, the market currently assigns nearly a 35% probability to the target rate ending the year in the range of 5% to 5.25%. Furthermore, the most likely range by November 2024 is projected to be 3.75% to 4%.

Patrick Armstrong, the chief investment officer at Plurimi Group, emphasized the dual risks associated with the current market positioning. Armstrong suggested that if Powell decides to cut rates, he might opt for a more substantial reduction than what the market expects. However, there is also a greater than 50% chance that Powell will maintain the status quo until year-end due to the strength of the services PMI, the robust employment backdrop, and strong consumer spending. In such a scenario, the Fed would not need to inject additional liquidity unless a debt crisis were to occur.

The European Central Bank (ECB) confronts a similar predicament, having recently reduced the pace of its interest rate hikes from 50 basis points to 25 basis points at its May meeting. The ECB’s benchmark rate now stands at 3.25%, a level unseen since November 2008.

In April, headline inflation in the eurozone rose to 7% year-on-year, although core price growth experienced an unexpected slowdown. This has sparked a debate on the appropriate pace of rate increases for the ECB to bring inflation back under control.

The eurozone economy grew by a meager 0.1% in the first quarter, falling short of market expectations. Despite this, Bundesbank President Joachim Nagel stated that several more rate hikes will likely be necessary, even if they risk pushing the bloc’s economy into a recession.