Three factors will determine whether central banks can navigate a soft landing of continued growth with prices rising at acceptable levels, or whether they miss an uncomfortably short runway:

• The pace of rate hikes required for central banks to assert their inflation-fighting credibility.
• How much wage and inflation expectations rise in defiance of that credibility.
• The incidence of additional unanticipated shocks to supply or demand.

Whether central banks succeed in delivering a soft landing will depend in part on how high they raise rates above the neutral rate, and how long they keep them there.¹

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.)

Euro area headline inflation rose to 7.4% in March. More than half the latest surge was attributable to energy prices, a component less likely to translate into higher persistent inflation. Inflation in the U.S. has been more broad-based—and thus more likely to persist—with only around a quarter recently attributable to energy prices. Moreover, the pace at which wage and inflation expectations could rise in defiance of central bank credibility appears higher in the U.S. compared with the euro area.

The path of interest rates over the next 12 months is not predetermined. It will depend on forthcoming data and unanticipated shocks. A further round of disruptions to supply—owing, for instance, to the spread of the COVID-19 Omicron variant in China or restrictions on the flow of natural gas between Russia and Europe—would likely stoke global inflation.

Uncertainty surrounding Russia’s invasion of Ukraine is a more immediate concern than inflation in the euro area, given the region’s proximity to the conflict. Consumer confidence is down. Any hints of weakness in forthcoming GDP readings will likely become part of the ECB’s rate-setting calculus. 

Inflation has reached levels that many parts of the developed world haven’t seen for 30 to 40 years. That makes the current bout of fast-rising prices a crucial test for central banks, some of which started targeting inflation in the early 1990s.

We believe that a soft landing in the U.S. is possible, but more than that, we believe the Fed will do whatever it takes to bring inflation under control. When all is said and done, inflation back at central banks’ 2% targets will benefit businesses and households alike. Low and stable inflation engenders the confidence that economies need to thrive.