Almost all central bankers in the United States and Europe agree that rates must rise to combat soaring inflation. What is open to debate is where they should stop.
Monetary policymakers and markets are trying to gauge where the “Goldilocks,” or neutral rate level, is – the optimal level where an economy is neither overheated nor dampened. But, after nearly 15 years of tepid inflation and ultra-low borrowing costs, no one really knows what “just enough” looks like.
“Everyone is trying to figure out where the neutral rate is and where the tightening cycle will end,” said Camille de Courcel, head of G10 rates strategy in Europe at BNP Paribas. “This will be the determining factor for the rates markets in the months to come.”
The risk is that policymakers get it wrong and let inflation spiral out of control by keeping rates too low, or trigger a brutal recession by rising too much. US Federal Reserve Chairman Jay Powell said he hoped for a “soft landing” but warned last week that rising rates could cause “some pain”. Bank of England Governor Andrew Bailey has spoken of a “narrow path” to contain inflation without reversing growth. European Central Bank President Christine Lagarde said “there are many challenges we still face.”
The neutral rate, where price pressures abate and production is close to capacity, cannot be measured, only estimated. It’s also a rolling target that changes over time — before 2008 it was thought to be around 5% in advanced economies.
Fed officials believe it is now between 2 and 3%, while inflation is at 2%. They raised interest rates by 50 basis points to 1% in their last vote and are expected to raise borrowing costs by another 50 basis points in each of their next two votes, leaving them on track for reach the range later this year. Others think the neutral rate is higher; Bill Nelson, former deputy director of the monetary affairs division of the Fed’s board of directors, who is now chief economist at the Bank Policy Institute, puts it between 4.5% and 6.5%.
The BoE believes that neutrality is even weaker in the UK. Their forecasts show that inflation consistently exceeds the 2% target if interest rates remain at their current level of 1%, but falls short of that target if rates rise to 2.5%. This suggests that the Monetary Policy Committee believes the right level is somewhere between the two bounds.
Eurozone politicians believe it is even lower. The governor of the French central bank, François Villeroy de Galhau, puts the rate at around 1% to 2%, comparing it to “the moment when, while driving your car, you take your foot off the accelerator pedal at the approaching the desired speed”.
Fears are growing that neutral is not enough. Behind closed doors, officials are growing increasingly concerned that their economies are now so hot that rates will have to slam on the brakes. Inflation, now at multi-decade highs on both sides of the Atlantic, could prove more rigid than expected, forcing them to tip the economy into a deep contraction, as did Fed Chairman Paul Volcker, did so in the early 1980s when he raised the federal funds rate. at 20 percent. Vicky Redwood, a former BoE official who is a senior economic adviser at Capital Economics, said: “If high inflation has become more entrenched than we think, then a Volcker-shock-type recession will likely be required.”
Krishna Guha, a former Fed staffer who is now vice chairman of Evercore ISI, said the question facing all central banks was “will you be forced to go beyond the neutral rate? , even if you then have to come back down once inflation is under control”.
Powell said on Tuesday that the Fed will “have no hesitation” in raising rates above neutral if inflation remains elevated, adding that officials do not know with “any confidence” where neutrality lies. “They will try in the first phase to get back to neutral, then they will assess,” said Jean Boivin, a former central banker in Canada now at BlackRock, predicting that by then “the world will be very different from where it is. is right now”.
As figures released on Wednesday are expected to show UK inflation hit new highs in the year to April, the BoE – which has already hiked rates three times this year – is under massive pressure to intensify his response. Michael Saunders, one of the MPC hawks, said the central bank should move “relatively quickly to a more neutral stance”, although he gave little guidance on whether to raise rates beyond that. .
Lagarde made it clear that the ECB, which has yet to raise its deposit rate by minus 0.5% but is expected to do so for the first time in a decade in July, aims to “normalize” rather than “tighten “monetary policy, towards the neutral rate but not beyond.
The ECB President signaled last week that the ECB was in less of a rush than the Fed to achieve neutrality, saying, “The process of normalization will be gradual.” But Dutch central bank chief Klaas Knot on Tuesday became the first senior ECB official to raise the prospect of a half-point rate hike in July, rather than the quarter-point hike. widely expected item.
As well as being more exposed to the conflict in Ukraine, the ECB is also hampered by the risk of a spike in borrowing costs in heavily indebted southern European countries like Italy.
The gap between Italy’s 10-year borrowing costs and Germany’s has already become the widest since the pandemic caused turmoil in debt markets in 2020.
While some ECB officials have spoken of launching a “new instrument” to counter this risk, without a firmer commitment, Guha said “spreads could explode and force the ECB to suspend rate hikes.”