EXPLAINER: Decoding Fed, ECB rate signals

Both the US Federal Reserve and the European Central Bank have hiked interest rates by 25 basis points in their latest monetary policy actions. However, there is a greater chance the Fed might pause with the ECB stating outright it would not do so. FE takes a look at the implications of the actions and commentary

What has been the impact of the Fed’s rate hikes so far?

The Fed’s monetary policy tightening actions over the past 15 months have taken the target rate to 5-5.25%, the peak of the 2004-2006 cycle. However, the pace of the tightening, this time around, has been far quicker, at 500 bps compared with 425 bps over two years in the 2004-06 cycle.

Consequently, the impact has been severe, resulting in mortgage rates more than doubling. Interest rates on auto loans are up and borrowing on a credit card is costlier.

Federal Reserve chair Jerome Powell said tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring

and inflation.

Is the Fed done with fighting inflation?

In the March statement, the FOMC said it anticipates that some additional policy firming may be appropriate, but that sentence was absent in the May statement. Instead, it now said that to determine the extent to which additional policy firming may be appropriate to return inflation to 2% over time, the committee would “take into account certain factors”.

Powell noted this is “a meaningful change — that we’re no longer saying that we anticipate (hikes)”. In May, the Fed went ahead with a hike despite fears of a recession and a banking crisis possibly because while inflation has come off from a peak of 9.1% in June last year to 5% in March, the levels are much above the Fed’s target rate of 2%. However, Powell’s observation that the labour market is better balanced is noteworthy.

Rate sufficiently restrictive?

The May statement dropped the reference to “sufficiently restrictive”, suggesting this may be the final hike.

However, Powell said it isn’t possible just yet to say with confidence that rates have reached that point. At the same time, he did indicate real rates may be “meaningfully above” estimates of neutral rates, at 2 %. And he said, “policy is tight”, as seen in interest-sensitive activities.

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The ECB hike

The ECB’s smallest rate increase yet in its fight against inflation, of 25 bps (to 3.25%), after three hikes that were twice this level, doesn’t mean it will pause. Although the rates are now at 2008 levels, ECB president Christine Lagarde unequivocally said there was “more ground to cover” and it was “extremely clear” the ECB wasn’t pausing.

In fact, some of her colleagues had favoured a bigger move and the Governing Council said future decisions will remain data dependent.

Tighter credit conditions amount to rate hikes

Fed Chair Jerome Powell has said that while it is impossible to estimate this precisely, in principle, that’s the idea.

Powell noted that the Federal Reserve “won’t have to raise the rates quite as high as we would have had this not happened”. Essentially, when interest rates are raised, it raises the price of credit and that, in a sense, restricts credit in the economy working through the price mechanism.

When banks raise their credit standards that can also make credit tight and in a kind of broadly similar way. Powell, though, had noted that the extent of the effect of tighter credit conditions is not known.

Can the Fed pause, given the substitute effect?

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Chair Powell says the appropriate extent of additional tightening would be decided meeting by meeting.

While the Federal Reserve does have a broad understanding of monetary policy, credit tightening, it says, “is a different thing”. Translating credit tightening into rate hikes, actually adds to the uncertainty and makes things more complicated.

Nonetheless, it will monitor the data on credit conditions and keep track of what’s happening with lending, as credit tightening could slow the economy more than expected. All this will be factored into its decision-making.