Economists at Goldman Sachs said that as the Bank of Japan maintains its hawkish stance on negative interest rates, the rate differentials between the United States and the Bank of Japan will persist.
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The US Federal Reserve, Bank of Japan, and European Central Bank will all announce crucial interest rate decisions this week, as they are each likely approaching a pivotal moment in their monetary policy path.
As Michael Cahill, a strategist at Goldman Sachs, put it in an email Sunday: “This week should be critical.”
“The Fed is expected to deliver what could be the final rally of a cycle that was one for the books. The ECB is likely to signal that it is nearing the end of its own cycle away from negative rates, which is a ‘mission accomplished’ in itself. But as it nears its end, the BoJ could outpace it all by finally breaking out of its starting blocks.”
Each central bank faces a very different challenge. The Federal Reserve, which wraps up its monetary policy meeting on Wednesday, last month paused its 10 consecutive hikes in interest rates as consumer price inflation fell in June to its lowest annual rate in more than two years.
But the core CPI rate, which excludes volatile food and energy prices, remained up 4.8% year-on-year and 0.2% month-on-month, albeit at its lowest level since October 2021.
Policymakers have reiterated their commitment to bringing inflation down to the central bank’s 2% target, and the recent influx of data has reinforced the impression that the US economy has proven resilient.
The market is certain that the FOMC will opt for a 25 basis point hike on Wednesday, taking the target federal funds rate to between 5.25% and 5.5%, according to the CME Group FedWatch tool.
However, with inflation and the labor market steadily declining, a rally expected on Wednesday could signal the end of 16 months of very tight monetary policy.
“The Fed has reported a willingness to raise interest rates again if necessary, but a July hike could be the last – as markets currently expect – if labor market and inflation data for July and August provide further evidence that wage and inflation pressures have now eased to levels consistent with the Fed’s target,” economists at Moody’s Investors Service said in a research note last week.
“However, the FOMC will maintain a tough monetary policy stance to help keep demand and, in turn, inflation at bay.”
This was echoed by Steve Englander, head of global G10 foreign exchange research and North American macro strategy at Standard Chartered, who said the discussion going forward would be about the guidance the Fed is giving out. Several analysts over the past week have suggested that policymakers will remain “data-driven”, but resist any talk of interest rate cuts in the near future.
“There’s a good argument that September should skip unless there’s a big surprise in inflation, but the FOMC may be wary of giving somewhat moderate guidance,” Englander said.
“In our view, the FOMC is like a weather forecaster who sees a 30% chance of precipitation, but skews the forecast to precipitation because the fallout from an incorrect sunny forecast is perceived as greater than an incorrect precipitation forecast.”
European Central Bank
Negative inflation surprises have also emerged in the Eurozone recently, with consumer price inflation in June across the bloc reaching 5.5%, the lowest level since January 2022. However, core inflation remained high at 5.4%, up slightly over the month, and both numbers are still well above the central bank’s target of 2%.
The European Central Bank raised its main interest rate by 25 basis points in June to 3.5%, breaking from the Fed’s pause and continuing a series of increases that began in July 2022.
More than 99% reversed market rates, according to Refinitiv data, up a further 25 basis points at the close of Thursday’s European Central Bank policy meeting, and key central bank figures reflected transatlantic peers in maintaining a hawkish tone.
Philip Lane, chief economist at the European Central Bank, last month warned markets against pricing in rate cuts over the next two years.
With a quarter-point hike however predetermined, as with the Fed, the main focus of Thursday’s ECB announcement will be what the Governing Council signals about the future path of interest rates, said Paul Hollingsworth, chief European economist at BNP Paribas.
“In contrast to June, when Chair Christine Lagarde said that ‘it is very likely that we will continue to raise rates in July’, we do not expect her to pre-commit the council to another hike at the September meeting,” Hollingsworth said in a note last week.
“After all, the recent comments suggest there is not even strong conviction among hawks for a September increase, let alone a broad consensus to indicate the possibility indeed this month.”
Given this lack of a clear data-driven direction, Hollingsworth said traders will be reading between the ECB’s communication lines to try to establish a bias towards tightening, neutrality or pause.
“Future Governing Council decisions will ensure that key ECB interest rates will reach levels constraining enough to achieve a timely return of inflation to the medium-term target of 2% and will be held at these levels for as long as necessary,” read the ECB’s opening statement at its latest meeting.
BNP Paribas believes this remains unchanged, which Hollingsworth noted represents an “implicit bias for further tightening” with “room to maneuver” should incoming inflation data disappoint.
He added that “the message in the press conference could be more subtle, suggesting that more may be needed, rather than more being needed.”
“Lagarde could also choose to reduce focus in September by pointing to the possibility of a Fed-style ‘skip’, which would leave open the possibility of a rate hike at subsequent meetings.”
Bank of Japan
Beyond the debate in the West about the latest monetary tightening, the question in Japan is when the Bank of Japan will become the last monetary policy auditor.
The Bank of Japan held its short-term interest rate target at -0.1% in June, after adopting negative rates for the first time in 2016 in hopes of spurring the world’s third-largest economy out of prolonged “stagflation,” characterized by low inflation and slowing growth. Policymakers also kept the central bank’s yield curve control policy unchanged.
However, first-quarter growth in Japan was revised sharply higher to 2.7% last month while inflation has remained above the Bank of Japan’s 2% target for 15 months in a row, reaching 3.3% year-on-year in June. This led to some early speculation that the Bank of Japan might have to finally start reversing its ultra-loose monetary policy, but the market still didn’t put any price adjustments or YCC into action on Friday’s announcement.
Yield curve control is widely considered a temporary measure in which the central bank targets a long-term interest rate, and then buys or sells government bonds at the level necessary to reach that rate. Under YCC policy, the central bank targets short-term interest rates at -0.1% and the 10-year government bond yield at 0.5% above or below zero, aiming to maintain an inflation target of 2%.
Barclays noted on Friday that the output gap – a measure of the difference between actual and potential economic output – was still negative in the first quarter, while real wage growth remained in negative territory and the inflation outlook remained uncertain. BoE economists expect a shift away from the YCC at the October meeting, but said splitting the vote at this week’s meeting could be important.
Christian Keeler, Head of Economic Research at Barclays Bank, said: “We believe the Policy Council will reach a majority decision, with votes split between relatively hardline members emphasizing the need to review the YCC (Tamura, Takata) and more neutral members, including Governor Ueda, and the dovish (Adachi, Noguchi) members of the reflexive camp.”
“We believe this departure from the unanimous decision to maintain the YCC can enhance market expectations for future policy reviews. In this context, the July post-MPM press conference and August 7 summary of opinions will be particularly important.”