May 04, 2023
U.S. and euro area investors for months have been sending central banks the message: You’re going to cut interest rates in 2023. The Federal Reserve and the European Central Bank (ECB) have responded: Not so fast.
Commentary by Roger Aliaga-Díaz, chief economist, Americas, and head of portfolio construction, and Jumana Saleheen, chief economist, Europe.
Even as the Fed and the ECB have raised interest rate targets steadily, investors, concerned about the prospects for recession, have priced in rate cuts by year’s end. They’ve done so through both complex derivatives tied to interest rates and the inversion of the yield curve—an abnormal condition in which short-term bonds yield more than their long-term counterparts.1
Again this week, however, both the Fed and ECB raised their rate targets by 25 basis points (0.25 percentage point), emphasizing that inflation remains too high.
On May 3, Fed policymakers raised their target for short-term U.S. interest rates for their 10th successive policy meeting in little more than a year. The hike took the rate target to a range of 5% to 5.25%—500 basis points above its level before the Fed embarked on one of the more aggressive inflation-fighting campaigns in its 110-year history.
On May 4, the ECB enacted its 7th rate hike in less than a year. The deposit facility rate, the annualized rate of interest banks earn on overnight deposits with the central bank, is now 3.25%—375 basis points above its level before the ECB initiated its inflation-fighting campaign. Its effort to subdue price increases began with rates in negative territory.
In remarks after their respective policy meetings, the heads of the central banks told investors, in effect: “We’re not cutting rates anytime soon.”
Vanguard still expects the Fed to raise rates another time or two this year and maintain its peak rate target until 2024. We expect the ECB deposit facility to peak at 3.75% to 4% this year and for the central bank to maintain the peak rate until 2024. We also recently increased our expectation for the Bank of England’s (BOE’s) terminal rate, to a range of 4.75% to 5% from our previous expectation of 4.5%. The BOE next meets on May 11 and is expected to raise rates from the current 4.25% to 4.5%.
To bring inflation closer to their 2% targets, Vanguard believes all three central banks will need to continue tightening monetary policy. Both the Fed and the ECB pointed to still-too-high rates of inflation in lifting interest rates this week.
The chart below shows the latest headline inflation readings of 7.0% in the euro area and 5.0% in the U.S. but also the recent downward trend on both sides of the Atlantic.
Central bankers have most recently been concerned with rising prices for services and their greater contribution to headline inflation, which is captured in the bottom panel of our chart. Services inflation is important because it is a good guide to where headline inflation will likely settle in the medium term.
Note: The U.S. chart reflects data for the period January 2019–March 2023. The euro area chart reflects data for the period January 2019–April 2023. Core goods include all goods except for food and energy. Negative contributions to inflation—most notably by energy prices in 2020 after the onset of the COVID-19 pandemic—reflect outright price declines.
Sources: Vanguard calculations, based on data from the U.S. Bureau of Labor Statistics and Eurostat, the European Union’s statistical agency.
Central bankers may be able to end their rate-hiking cycles before rates fall to target in part because monetary policy changes typically take months to work through an economy. In any case, Fed Chair Jerome Powell and ECB President Christine Lagarde have said that once policy rates reach their peak, they will have to stay high—in territory that restricts economic activity—for some time.
What’s restrictive monetary policy territory?
One definition deems a policy rate restrictive when real interest rates—nominal rates of interest minus rates of inflation—are positive. By this measure, real rates remain firmly negative in the euro area. In the U.S., they have turned marginally positive for some measures of inflation but not others.
A second definition deems a policy rate restrictive when it exceeds the “neutral rate of interest”—a theoretical rate that neither stimulates nor inhibits economic growth but supports the status quo. The Fed’s current rate target is roughly double its estimated range of the U.S. neutral rate. Similarly, in the euro area, the ECB deposit rate is roughly double that of some neutral rate estimates.
Taken at face value, the excess of policy rates over neutral rates suggest that rates are in restrictive territory. However, given that the neutral rate is not directly observable and can only be estimated with a large margin of error, it is hard to be confident we are there.2
While measuring the effects of monetary policy will remain challenging, doing too little to quell inflation would threaten the living standards of millions. That’s why we believe the Fed and ECB will continue to raise rates, even though such strong hiking cycles often end in recession.
We continue to expect recession in several developed markets in 2023 and that investors will need to wait at least until 2024 for rate cuts.
In the meantime, our outlook for long-term portfolio returns has increased since the start of rate-hiking cycles as equity valuations have fallen back to more sustainable levels and coupons for new bonds pay healthier rates.
1 For example, as of the close of trading on May 3, 2-year U.S. Treasury notes yielded 53 basis points (0.53 percentage point) more than 10-year U.S. Treasury notes. In theory, longer-term bonds should yield more than shorter-term bonds to compensate investors for the extra risk inherent in loaning money to bond issuers for longer periods.
2 For more information and perspectives on neutral rates, see our June 2022 research paper, Estimating neutral rates: Why the era of ultra-low rates may be coming to an end (21-page PDF).
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