As 2022 draws to a close, we ponder the lessons from this year of rate increases. While the Fed may have accomplished its mission, Eurozone inflation remains high and the ECB has limited room for manoeuvre. Its footwork must be precise in the face of major risks, in particular a misstep which could destabilise the financial system.
A three-point review
In the face of the 2022 inflationary shock, central banks raised their key rates in an unprecedented and almost unanimous manner. As the year-end approaches and a recession looms, it is time to take stock.
Three lessons can already be drawn from this period.
- Central banks are very poor forecasters. Their forecasts have consistently underestimated inflation – let us not forget the ECB’s forecast.
- The copy-cat effect on monetary policy has once again undermined independence. The Fed was thus the first and the most aggressive in its monetary tightening, echoed by all its counterparts.
- The fight against inflation has become a priority for central bankers, at the risk of tipping the global economy into a major slowdown.
What do we see for 2023?
Even if inflation is expected to ebb, we expect it will remain well above the target of 2%, forcing central bankers to maintain higher rates for a longer period. More structural factors such as demographic changes and the energy transition could weigh more structurally on prices. Against this backdrop, the major challenge in 2023 will be forecasting the terminal rate of each region.
In the United States, the Federal Reserve pushed the most aggressive increase in its key interest rate in 40 years. Mission accomplished. With four exceptional increases of 75 basis points, bringing the Fed Funds rate to 4%, and an ambitious policy of reducing its balance sheet, the Fed managed to slow inflationary momentum without destabilising the US financial system. We expect that in 2023 the central bank will announce two further rate increases, stabilising around 5.25%. The management of the terminal rate will be a delicate exercise given that household savings mask the delayed effects of the increase in long-term rates on the economy.
In the Eurozone, the ECB put an end to its negative rates by raising them at a never-before-seen pace of more than 200 basis points in five months. But inflation is not yet under control, now hovering above 10% ¹. If energy prices should stabilise in 2023, the recent agreement obtained by German employees for a wage increase of 8.5% over two years ² would raise fears of a wage-price spiral. Moreover, European governments have renounced budgetary orthodoxy and are supporting consumption at the risk of maintaining a higher-than-optimal level of inflation. The monetary restriction initiated by the European Central Bank is thus far from an end. The ECB should continue to normalise in 2023 via several increases, bringing the deposit rate to 3%. The task will prove even more difficult as budgetary policies partially offset the effects of a restrictive monetary policy. The ECB should increase its rates while the Fed will have already reached its terminal rate – delicate steps will be needed to avoid an excessive appreciation of the Euro.
Beyond these rate forecasts, two major risks should be monitored in 2023
The risk of losing independence. The Liz Truss drama in the UK underscored the dangers of a potential collusion between budgetary and monetary policy. History could repeat itself.
The risk of a tightening error. Too many rate increases could destabilise the financial system via the linkage with pension funds or real estate. While such an error has thus far been avoided, it will be necessary to monitor this risk in the coming year.
The ball of monetary tightening should come to an end in 2023; hopefully, a better end than a ‘march to the scaffold’.
¹ Source: Eurostat
² Source: IG Metall
