By José Torres

In what may be a preview of next week’s Federal Reserve meeting, the European Central Bank has stuck by its inflation-fighting guns by hiking its key interest rate by 50 basis points, despite growing fears about banking stability and various indicators depicting disinflation in the U.S.

Investors have been watching to see what part of the economy breaks under the stress of tightened monetary policy as central banks take aggressive actions to fight inflation. Many investors have hoped the economic distress, such as banking problems, would cause central banks to become less hawkish.

Throw into the mix recent U.S. reports of declining consumer spending and disinflation for supplier prices, according to the Producer Price Index, and the combined result caused investors to become increasingly optimistic that central banks would back off their inflation battle.

During its meeting this morning, however, the ECB raised its deposit rate 50 bps, bringing the rate to 3% but it also reduced its inflation forecast. In December, it forecasted that headline inflation and core inflation this year would hit 6.3% and 5.3%, respectively, but during its recent meeting, it lowered those numbers to 4.2% and 4.6%. The ECB rate hike, however, has resulted in investors lowering their expectations for the ECB’s terminal rate from 4.2% last week to 3.2%.

Market participants are now turning their attention to the tight U.S. labor market and next week’s meetings of the Fed and the Bank of England.

Last week, inflation-weary investors welcomed the news that U.S. labor conditions may be easing with initial jobless claims increasing by 22,000 during the week ended March 3, but the optimism was short-lived with the Labor Department reporting recently that initial jobless claims actually declined by 20,000 last week.

Also released this morning, building permits and housing starts reaccelerated in February, coming in above expectations, as lower relative rates propelled activity in the real estate sector.

Powell and central bankers alike need to thread the needle with prowess as they manage their priorities of inflation and financial stability because since the middle of 2022, any relief on the interest rate front has led to a short-term boost in economic activity and as a result, more inflation.

Inflation hawks who believe regulators have thwarted a widespread contagion of bank instability following the failures of SVB and Signature Bank maintain that the Fed needs to remain aggressive and hike the fed funds rate 50 bps. They point to Fed Chairman Jerome Powell’s earlier comments that the central bank is open to increasing the intensity of its rate hikes if inflation persists. At the moment, however, odds of 82% significantly favor a 25bp hike at next week’s meeting.

(Author is Senior Economist at Interactive Brokers)

2023-03-17T14:28:58Z dg43tfdfdgfd