Partner Insight: Central Banks Step Into Potential Policy Error Territory

Hawkish stances risk overtightening and causing recession

clock • 4 min read
Partner Insight: Central Banks Step Into Potential Policy Error Territory

Could we be entering the zone of a global monetary policy mistake? Recent hawkish stances taken by some major developed market central banks make this a valid question. There is now a meaningful risk that these central banks could overtighten in their quest to quell inflation and help push the global economy into recession as well as induce a financial market recession. China's central bank, on the other hand, may be making a different type of policy error by not easing policy enough to support the country's economy.

European Central Bank (ECB)

The ECB provided what is probably the most obvious recent example of an extremely hawkish position from a major central bank. At its June meeting, the ECB raised rates by 25 basis points (bp) and President Christine Lagarde said to expect another hike in July. Most significantly, it surprised the markets by raising its 2025 inflation forecast—consensus expectations had been for a decrease in the inflation outlook, so the increase sent a strong hawkish signal.

As a result of this revised forecast for higher inflation, we think the ECB could even hike again at its next meeting in September. However, like most central banks, the ECB does not have a strong track record for accurately predicting inflation, so there's a distinct possibility that inflation will be lower than forecast—resulting in overtightening of monetary policy.

Federal Reserve Bank (Fed)

Although the Fed kept rates steady at its June policy meeting following 10 consecutive increases totaling 500 bp, the Summary of Economic Projections (SEP) showed that policymakers expect to raise rates twice more in 2023. Fed Chair Jerome Powell underscored the Fed's seemingly muscular approach to taming inflation by declaring that rate cuts are unlikely for a couple of years. This may have been part of an effort to convince markets not to price in cuts this year, and it worked—futures contracts post‑Fed meeting showed rate decreases starting in early 2024. However, Powell's comment about not expecting cuts until 2025 was at odds with the SEP's projections, which showed 100 bp of easing in 2024.

The Fed indicated that it will take into account the cumulative effects of policy tightening when determining how much more to raise rates, signalling that it is likely to take more time between hikes. But will that prove adequate to forestall a recession? The stickiness of core U.S. inflation and the Fed's focus on returning inflation to its 2% target could easily lead the Fed to move rates too high and be slow to cut when the economy enters recession.

 

 

This post was funded by T. Rowe Price

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