From Silvia Dall’Angelo, Senior Economist at Federated Hermes Limited, London
US economic data had a generally softer tone this week, suggesting the impact from past monetary tightening is gradually spreading across the real economy, while the recent episode of stress in the banking sector has probably taken a toll on sentiment. Overall, we expect the Fed to hike by 25 basis points to 5-5.25% next week, in line with consensus’ expectations. With financial stability concern now front and centre, the Fed is likely to pause after its May move. That would also allow the Fed to assess the impact from monetary tightening on the real economy, which should become more meaningful at about this stage, given the typical lags in the transmission mechanism. However, as a tight labour market is still a source of inflationary pressures, the Fed will likely hold at its peak rate for longer than financial markets currently expect.
European economic data has remained solid recently, likely emboldening the ECB’s resolve to tackle inflation – they will proceed with their tightening cycle next week, while also likely maintaining a hawkish tone. Recent survey developments suggest the fallout from the recent stress in financial markets on economic activity has been limited so far. Indeed, the Euro Zone flash PMI surveys for April signalled ongoing improvement, notably in services sectors, suggesting domestic demand has remained strong. That was confirmed by the German IFO survey, which also came in slightly better than expected in April.
Also read: Credit Default Swaps and Credit Suisse
The ECB will likely hike rates by either 25 basis points or 50 basis points next week, depending on forthcoming information on inflation and credit conditions. The ECB is now contending with a dilemma involving price stability and financial stability considerations. Inflationary concerns have remained front and centre, as wage inflation has trended higher (breaking 5% in Q4 22) and wage negotiations point to additional short-term pressures (most recently, the German public sector has struck a strong pay deal). However, as the current hiking cycle has been the fastest in the ECB’s history, there is a strong case to slow down the pace of tightening to assess its impact on the financial system and the real economy. Indeed, the risk of a serious accident in financial markets – impairing the smooth transmission of monetary policy – has increased significantly as monetary conditions have abruptly shifted from extremely accommodative to somewhat restrictive.
In my base case, the ECB is close to its peak rate. Granted, the re-emergence of stress in financial markets would disrupt the ECB’s tightening plans with respect to both interest rates and the balance sheet.
