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Pressure on the ECB increases: US Federal Reserve proposes rate hike

Pressure on the ECB increases
US Federal Reserve proposes rate hike

“Inflation is far too high,” warns the head of the Federal Reserve. The US Federal Reserve wants to counteract the high prices by raising interest rates. That could cloud the economy and the labor market. Nevertheless, expectations of the ECB to follow the US example are increasing.

In view of the highest inflation rate in the United States for decades, the US Federal Reserve (Fed) is now taking action: It is raising its key interest rate significantly by 0.5 percentage points and signaling a “rapid” further tightening of its monetary policy. “Inflation is way too high,” Central Bank Governor Jerome Powell told reporters. “We will act quickly to lower them again,” he promised. At the next meetings of the Central Bank Council, increases of 0.5 percentage points should therefore be forthcoming, said Powell. In addition, starting in June, the Fed is reducing its balance sheet, which will drain the markets of tens of billions of dollars in liquidity every month.

The Fed’s resolute course is also likely to increase pressure on the European Central Bank (ECB) to reverse course towards fighting inflation. “The Fed is moving forward boldly,” commented the chief economist at VP Bank Group in Liechtenstein, Thomas Gitzel. “The ECB should now take the baton and also make it clear that several interest rate hikes are to be expected in the current year,” he wrote. The Fed strengthens its credibility with its clear communication, “the ECB, on the other hand, gambles it away,” he wrote. The chief economist at Targobank, Otmar Lang, said, referring to ECB boss Christine Lagarde, that the ECB should take the Fed as an example: “Ms. Lagarde, that’s how it works!”

Europe’s monetary watchdogs have already decided to phase out their multi-billion dollar bond purchases more quickly. In addition, several members of the Governing Council of the ECB recently suggested an initial rate hike in July. Financial markets are expecting the ECB to raise the deposit rate, at which banks can park money with it, from minus 0.5 percent to 0 percent this year. The key interest rate, which has been at a record low of 0 percent for more than six years, could then be raised in 2023. Inflation in the euro area hit a record high of 7.5 percent in April. In the USA, the world’s largest economy, the inflation rate was 8.5 percent compared to the same month last year.

“It will not be easy”

The US inflation rate has been well above the central bank’s medium-term target of two percent for many months. Now the central bank is taking countermeasures: With its interest rate hikes, the Fed wants to make loans more expensive quickly in order to curb demand overall. This helps bring down the rate of inflation, but it also weakens economic growth. It is therefore a dangerous balancing act for the central bank: it wants to raise interest rates so quickly and so much that inflation is slowed down – but without stalling the economy and the labor market at the same time.

Powell explained that the goal is to use the central bank’s tools in such a way that supply and demand adjust again and inflation comes down. The economy should cool down in a way that will not lead to a recession. “I expect that to be a big challenge,” Powell said. “It will not be easy.” However, there are currently so many vacancies on the job market that even a slight slowdown in the economy is unlikely to increase unemployment, said Powell.

As a result of the hike announced on Wednesday, the policy rate is now in the range of 0.75 to 1 percent. It was the second interest rate increase since the beginning of the corona pandemic – and the first increase of 0.5 percentage points in 22 years. Usually, the Fed prefers to raise interest rates in 0.25 percentage point increments. The decision was largely expected by the markets. When asked, Powell explained that even more drastic interest rate hikes of around 0.75 percentage points are not currently to be expected – a comment that was welcomed with relief on the financial markets.

The consequences of the Russian war of aggression in Ukraine, for example with a view to rising energy and food prices, are increasing inflationary pressure and are likely to weigh on the economy, Powell explained. The corona lockdowns in China are also likely to cause new disruptions in global supply chains, which could affect inflation and growth. Financing costs for mortgages in the USA, for example, have already increased significantly as a result of the Fed’s tighter monetary policy.

Analysts expect further rate hikes

Critics, however, accuse the most powerful central bank of having reacted too late to the rise in prices. In her opinion, the central bank should have stopped its programs to support the economy from the Corona crisis and increased interest rates in the second half of last year. The Fed had largely described inflation in 2021 as a “temporary” phenomenon.

One challenge for the Fed is that it can only influence some of the causes of price increases to a limited extent. Disruptions in global supply chains and rising energy prices are not directly responding to US interest rates. The Fed is also unable to control the consequences of the war in Ukraine and the corona lockdowns in China. Analysts therefore expect further rate hikes this year. According to observers, the key interest rate could be at or above 2 percent by the end of the year.

The Fed also wants to quickly reduce its balance sheet, which has swollen to around nine trillion US dollars as a result of the Corona emergency programs. Starting in June, a total of $47.5 billion worth of expiring assets will not be renewed each month, the central bank announced. By September, the monthly total is expected to increase to $95 billion. This will drain further liquidity from the markets. The Fed is committed to the goals of price stability and full employment. The US economy is now booming again, with the unemployment rate recently falling to a low 3.6 percent. Many employers are already complaining that they cannot find enough candidates for their vacancies.

The Central Bank Council meets about every six weeks to decide on the course of monetary policy. The next session will end on June 15th. In view of the high inflation rate, the Fed stopped buying securities worth billions in March and increased its key interest rate by 0.25 percentage points for the first time since the Corona crisis.

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