Investors are pricing in a sharp rise in interest rates over the coming months after the world’s major central banks strengthened their resolve to tackle higher rates, signaling that they would prioritize inflation over growth.
FTSE analysis of interest rate derivatives, tracking borrowing costs expectations in the US, UK and eurozone, shows that markets expect a sharper pace of tightening during the last quarter of 2022 than they did earlier this year.
The shift in mood comes ahead of crucial policy meetings of the US Federal Reserve, the Bank of England, the central banks of Norway and Sweden, and the Swiss National Bank this week. It comes on the heels of a weak August inflation reading in the US and warnings from monetary policy makers on both sides of the Atlantic that they are becoming increasingly concerned that without significant interest rate increases, high inflation will be difficult to reverse.
“Central banks are dealing with how difficult it is to get inflation back to target, and they are trying to convey that message to the markets,” said Ethan Harris, an economist at Bank of America.
Rising expectations that central banks will raise interest rates, even if their economies fall into recession, have led to the World Bank’s concerns. The Washington-based organization warned last week that policymakers risk pushing the global economy into recession next year.
“Central banks will sacrifice their economies for recessions to ensure inflation quickly returns to their targets,” said Mark Zandi, chief economist at Moody’s Analytics. “They understand that if they don’t, and inflation will become more entrenched, it will eventually lead to more severe deflation.”
Since June, the world’s 20 major central banks have raised interest rates together by 860 basis points, according to Financial Times research.
As of Friday, markets were presenting a 25 percent chance that the US Federal Reserve would raise interest rates by 100 basis points on Wednesday and predicted the Fed’s target would be above 4 percent by the turn of the year — about a full percentage point higher than it had been. It is in early August.
Markets expect the ECB deposit rate to reach 2 percent by the end of the year, up from 0.75 percent now. The latest bet is more than one percentage point higher than investors expected in early August. Philip Lane, the European Central Bank’s chief economist, said at a conference over the weekend that he expects to raise interest rates “several times” this year and early next. He said this would likely involve some “pain” from lost growth and jobs to reduce demand, reflecting the European Central Bank’s growing concern that inflationary pressures are spreading from energy and food to other products and services.
Year-end interest rate expectations are also higher for the BoE, with economists largely split between a 50 basis point rise and a 75 basis point rise in Thursday’s vote.
The Swiss central bank is expected to raise its policy rate by 75-100 basis points next Thursday, ending a seven-year experiment with negative interest rates.
Paul Hollingsworth, chief European economist at BNP Paribas, said central banks were “carrying their own tightening cycles” despite signs of weak growth.
A major shift in market expectations came after policymakers such as Federal Reserve Chairman Jay Powell and European Central Bank Executive Board member Isabel Schnabel delivered hawkish messages at the Federal Reserve’s annual Jackson Hole conference in Kansas City in late August.
“This exciting voice you hear is the voice of policy makers pulling back the interest rate hikes that were previously projected to occur from 2023 to 2022,” Krishna Guha, vice president at investment banking advisory firm Evercore ISI, said after the meeting. “We’ve ended up globally with something that – looking at 2022 as a whole – will look more like a turbulent level change than a traditional tightening cycle.”
Since Jackson Hole, US inflation has proven more steady than expected, coming in at an annual rate of 8.3 percent in August. In the Eurozone, price pressures are expected to reach double digits in the coming months. The UK government’s £150 billion energy support package will reduce inflation in the short term, but will boost price pressures in the medium term by boosting demand.
Central bankers like Schnabel have pointed out that with inflation remaining near record levels for the foreseeable future, they are no longer willing to put their faith in economic models that show price pressures subsiding over the next two years.
While most of the inflation seen in Europe remains the result of the rise in energy prices caused by the war in Ukraine, there have been increasing signs in both the single currency area and the UK that price pressures are becoming more widespread and more entrenched.
“Usually, central banks view gains in these volatile rates as temporary,” said Jennifer McQueen, head of global economics at Capital Economics. “But in an environment where core inflation is already high and inflation expectations and wage negotiations seem to follow higher energy prices, monetary policy makers cannot take that risk.”
Additional reporting by Martin Arnold