More interest rate hikes

Silvan Mifsud is director of Advisory at EMCS Tax & Advisory

In its quarterly review, issued on the 27^th February, the Bank for International Settlements which is considered as the central bankers’ bank, has warned markets on the danger of overestimating the chances of interest rate cuts in 2024. As headline inflation readings gradually fell in recent months, the pace of policy tightening slowed.

However central banks have been very cautious in the communication about their policy outlook, particularly in view of the persistent strength of labour markets.  In essence, while headline inflation rates have fallen since the autumn on the back of a fall in commodity prices, cost pressures remain far higher than central bankers would like. For example, in the Eurozone, core inflation, which strips out changes in food and energy prices, and is seen as a better measure of underlying price pressures, hit a fresh record high of 5.3% in January 2023.

Notwithstanding this cautious tone,  investors’ sanguine attitude seems to have taken over, with interest rate futures continuing to indicate market expectations that rate hikes will end this year at a historically low level, followed by  rate cuts into 2024

The BIS warned that central banks have been very clear about the priority of getting the job done and of being cautious about declaring victory too early. In essence the BIS made it clear that any pricing of financial assets based on the expectation that interest rate hikes would stop before the end of 2023 and that policy rates would decline materially in 2024,  was in sharp contrast to cautious communications from rate-setters, who gave no indication that easing was on the horizon.

This quarterly review from BIS, seems to have been issued right on cue. Market expectations at the beginning of the year was that the US Federal Reserve, which has raised rates by 4% since March 2022, would begin cutting rates before the end of 2023 or early in 2024. However, this view has been heavily challenged in recent weeks by higher than expected US inflation figures and strong jobs data in February 2023. This resulted into a crumbling of a rally in global bond markets earlier this year, while stocks have fallen sharply. On the other hand, in the eurozone, where the ECB has raised rates by 3% since last summer, investors have started pricing in more rate rises over the coming months.

Claudio Borio, the head of the monetary and economic department at the BIS was reported as saying that  it was “much easier to get inflation from 8% to 4%, when the work is done by [falling] commodities prices, than it is to get it from 4% to 2%, which is the part that central banks will have to do”.  This signals that central banks should avoid the risk of relaxing interest rates too early and undoing all the work done so far.

So, the central theme on monetary policy is that further interest rate hikes are on the horizon and any expectation of any eventual reduction in interest rates, is based on unfounded speculation. Central Banks are concerned that early reduction in interest rates before inflation expectations  remain anchored at low level, would require much higher interest rate increases later.  This would surely push the economy into a recession.  The current macro-economic environment is too turbulent to create any sensible future scenario based on a reduction in interest rates. Central Banks priority is to bring inflation down to within their 2% target through a soft landing rather than a full blown recession.