Whether rate-setters will match their tough talk with a bumper rate hike will depend on what the US Federal Reserve does next. If last year taught us anything, it was that the Fed is the invisible hook on which the rest of the world’s rate-setters hang.
Central bankers did not formally cooperate last year. But they might as well have done it. When Jay Powell began raising interest rates last spring, the European Central Bank was still in wait-and-see mode and the Bank of England was making the modest quarter-point rate hikes favored by central bankers (and their watchers). .
By autumn, both the ECB and the BoE had followed the Fed’s lead and raised the jumbo rate by 0.75 percentage points—a significant pace of tightening that startled investors everywhere. By the end of the year, the Bank of Japan also delivered its own hawkish surprise.
Bless the weak US economy
The US monetary guardian was able to bring the rest in line through the sheer strength of the dollar. Central bankers are reluctant to give in to pressure from foreign exchange markets. But the extent of almost every major currency’s slide against the greenback — the euro was down about 16 percent at one point last year, the pound by more than 20 percent and the yen by nearly a quarter — scared them. Their response was to follow the Fed and supersize rates.
This year could be one of the rare occasions when a weak US economy turns out not to be dangerous, but a boon to the rest of the world, if it eases the pressure on Powell to raise rates. If the US central bank raises rates by a half-point to a quarter-point, that will give others room to adapt. The danger is that the US labor market continues to be hot and the Fed does not ease. Even with their economy in such a weak state, others will again feel the need to match its firepower.
The biggest risk for this year is that rate-setters become so paranoid about losing face that they put their money where their mouth is and not only talk tough but impose much larger rate hikes. A rapid increase in borrowing costs will almost certainly push economies into recession. They could also fuel the financial turmoil that makes last fall’s gilt market panic look like a blip.
LDI (liability-driven investment) would send mixed signals by forcing policymakers to expand pockets of financial markets while trying to tighten credit conditions, as was the case with the Bank of England during the panic. Rate-setters will face even more political pressure – in Europe, French, Italian and Finnish leaders have already complained that the ECB’s efforts to rein in inflation are putting jobs and growth on the line, while raising other sovereign debt risks. emergency
Focusing on non-inflationary threats will probably result in lower rate hikes. That, in turn, could keep prices rising at 3 or 4 percent a year for the foreseeable future, and the descent of inflation stops short of the 2 percent goal that rate-setters desire. It is not ideal. But, after a very messy 2022, sacrificing ambitions of a perfect landing for something more obscure may prove to be the worst option for everyone.
Financial Times
