Fed and BoE green light interest rate hikes, despite banking turmoil

The US Federal Reserve (Fed) raised interest rates by 25 basis points bringing its federal funds rate to a range of 4.75% to 5.00% on Wednesday evening. This marks the second straight quarter-point rise in base interest rates, bringing the federal funds rate to its highest level since 2007. Meanwhile, following the latest meeting of its Monetary Policy Committee (MPC), the Bank of England (BoE) today increased its base rate by 25 basis points to 4.25%. Seven of the nine committee members voted for today’s rise, with two preferring to keep the rate the same. The base rate is now at its highest level since November 2008, when it stood at 4.5%.

Further tightening of monetary policy by both central banks comes in response to the most recent economic data. In the US, while annual inflation – as measured by the Consumer Price Index – fell to 6.0% in February, on a monthly basis, inflation accelerated by 0.5% and 0.4% in January and February, respectively. This marks a break from the monthly deceleration seen in the three months prior to January, indicating the persistence of broad-based underlying price pressure. In conjunction with stronger-than-expected payroll figures in the first two months of the year, the Fed decided to further tighten monetary policy to rein in inflation. Meanwhile, in the UK, the latest data for annual inflation unexpectedly rose to 10.4% in February, buoyed by increased price pressure in the restaurant and hospitality, and food and non-alcoholic beverages categories, thereby ending a three-month stretch of disinflation, and highlighting the broad presence of price pressure in the UK economy.

However, the collapse of Silicon Valley Bank (SVB) in the United States and takeover of Credit Suisse in Switzerland have raised concerns about banking sector stability for policymakers across the world. While the Fed and the BoE have a clear mandate to bring down the rate of inflation to 2.0%, they are also tasked with maintaining the financial stability within their respective financial systems, and further interest rate rises risk placing pressure on a fragile system. This was a relatively larger concern to the Fed, given the American origin of SVB and Signature Bank, and the subsequent need to ensure financial stability amidst market turmoil.

The Fed also signalled an intent to end its rate hikes, ditching its often-repeated line in previous statements that “ongoing increases in the target range” will be appropriate to curb inflation, with the Federal Open Market Committee (FOMC) stating in its latest statement that there is some possibility of “some additional policy firming” in future meetings. Indeed, this is a far cry from Fed Chair Jerome Powell’s statements earlier in the month, where in congressional testimonies he hinted at a reversal back to larger, incremental hikes in base interest rates, amidst stronger-than-expected economic data, while reiterating that interest rates (were) “likely to be higher” than previously anticipated. Nonetheless, the change in stance on monetary tightening is reflective of the uncertainty that has stemmed from the recent banking crisis, and whether measures by the Fed have been adequate to avert a further implosion.

While statements from both the BoE’s Monetary Policy Committee (MPC) and the FOMC have reiterated the soundness and stability of their respective banking systems in a bid to calm markets, it is clear that recent events have affected the monetary policy outlook for both central banks. If the Fed and/or the BoE are forced to halt interest rate hikes prematurely in response to the fallout from the banking crisis, there is a possibility of upticks in the rate of inflation in the coming months. Consequently, central banks, including the Fed and the BoE find themselves in a precarious position, and will be monitoring developments in the banking sector closely to determine whether the banking system turmoil may have a disinflationary impact, and whether there is a need to curb interest rate rises. Nonetheless, the higher interest rates announced today combined with a possible worsening of access to credit due to banking problems paint a difficult picture for business activity, a key contributor to GDP growth. Overall, CEBR’s latest forecasts expect growth of 0.4% and -0.4% in 2023, for the US and UK, respectively, which would mark a significant slowdown from the 2.1% and 4.0% growth rates, for the UK and the US, respectively, seen in 2022.