Persistence in the Fed’s fight for inflation amid pause; Bank of England hikes higher than expected

Powell’s unbreakable vow

Fed Chair Jerome Powell spoke on Capitol Hill last week to both chambers of Congress, reiterating the long road ahead to reining in inflation. This came a week after the June FOMC meeting where the Fed decided to hold its federal funds rate at 5.0%-5.25%, after 10 consecutive interest rate increases. If one thing was clear from his testimonies before Congress, it is Powell has not broken his vow to fight inflation “until the job is done.” In other words, plans for any future rate cuts are a far cry from home with more rate hikes just around the corner.

While progress has been made towards fighting inflation — as May’s headline inflation fell to around half of last year’s peak — inflation remains well above the Fed’s 2% target. In his speech before Congress, Powell acknowledged the success in the Fed’s monetary policy to bring inflation down and reasoned that it, “may make sense to move rates higher but do so at a more moderate pace.” The decision to pause rates at the June meeting buys the Fed time to evaluate its monetary policy impacts and reveal suspected hidden implications of the banking crisis. The Fed expects the need for further rate increases as its updated economic projections have the median projected federal funds rate at 5.6% for 2023, implying two more rate hikes by the end of this year. In reference to these projections, Powell considers them, “a pretty good guess of what will happen if the economy performs as expected,” as he said in front of the House Financial Services Committee.

Despite talk of more rate hikes from the Fed, there is a disconnect with market expectations. According to the CME Fed Watch Tool, the market is pricing a ~75% probability of a final hike in July and expects the Fed to hold rates at 5.25%-5.50% before a series of aggressive cuts beginning in January 2024. The market seems confident that the Fed can engineer the soft landing.

A big splash across the pond

While the Fed takes a pause on rates hikes for now, other central banks raised their central bank rates 25 basis points in recent weeks, including the Bank of Canada, the European Central Bank, the Bank of Australia, and the Swiss National Bank. Last Thursday, the Bank of England went a step further, raising interest rates 50 basis points from 4.5% to 5.0%, its highest level since April 2008.

Earlier in the week, May inflation data for the U.K. came in stubbornly high. While consumer prices in May from a year earlier were unchanged from April at 8.7%, the core measure of U.K. inflation, excluding volatile food and energy, rose to 7.1%, its highest level in over three decades. This uptick can be largely attributed to services inflation as rising wages are pushing prices higher. The U.K. has struggled to grow ever since Russia’s invasion of Ukraine with a surge in energy and food prices; now coupled with a sharp rise in borrowing costs, the possibility of a recession lingers.

The markets react

Fed Chair Powell’s hawkish plans for further rate hikes this year sent the 2-year Treasury yield to 4.792%, its highest level since March, on Thursday. The yield on 10-year Treasuries advanced seven basis points to 3.79%. Also on Thursday, in reaction to the Bank of England’s higher-than-expected 50 basis point rate hike, GBP-USD jumped 60 pips to 1.2840 and retreated 100 pips to 1.2740 shortly thereafter. The pound eventually stabilized at the day-opening levels as markets digested the rate decision as consistent with recent economic data.

Friday morning, the euro fell sharply in response to a slowdown in German business activity in June as shown by the release of Purchasing Managers Index (PMI). Business activity in France also contracted in June—the first time in five months. Rates were down across the board as concerns about the world economy linger in the face of continued rate hikes from global central banks and data revealing economic slowdowns.

Following the Wagner paramilitary group’s revolt over the weekend, markets remain relatively unchanged as of Monday morning. Many commodity analysts are saying they don’t foresee a significant impact on oil prices in the near term unless a revolt erupts again, sending worries of further political instability.

The week ahead

All eyes will be on Friday’s release of Personal Consumption Expenditures data for May, the Fed’s preferred measure of inflation, to get a closer read on the certainty of the Fed’s plan to resume hikes in July. Markets will also monitor impacts from this weekend’s Wagner march on Moscow and any potential destabilization of the Putin-led government.