Market expectations of the terminal interest rate—the highest point in a rate-hiking cycle—have increased significantly since March. However, central bank challenges vary by region, and differences are readily apparent when comparing the United States with the euro area.
In the U.S., where headline inflation has soared to 8.5%, markets are pricing in a terminal rate of 3.5% by mid-2023. This likely reflects the expectation that the Fed will be aggressive in fighting inflation amid a tight labor market.
The chart also highlights the Fed’s exposure to potential policy error. Policy rates above neutral will be effective in fighting inflation precisely because they restrict economic activity—which increases the risk of recession. (An initial estimate of first-quarter U.S. GDP showed an unexpected economic contraction. This exemplifies the challenging signals that the Fed may encounter in the months ahead.)