A ‘momentous week’ ahead as the Fed, ECB and Bank of Japan near pivot point

The Federal Reserve, the Bank of Japan and the European Central Bank are all due to announce key interest rate decisions this week, each likely approaching critical points in their monetary policy trajectories.

As Goldman Sachs strategist Michael Cahill said in an email Sunday: “This should be a big week.”

G10 currency strategist Cahill said: “The Fed is expected to implement what may be the last rate hike of a cycle. The ECB may signal that its negative interest rate cycle is coming to an end, which in itself is a major ‘mission accomplished’.”

“But as they come to an end, the BOJ may eventually overtake them and end up where they started.”

the fed

Each central bank faces very different challenges. The Federal Reserve, which wrapped up its monetary policy meeting on Wednesday, paused its tenth straight rate hike last month as U.S. consumer price inflation fell to its slowest annual rate in more than two years in June.

However, the core CPI after excluding the volatile food and energy prices still rose by 4.8% year-on-year and 0.2% month-on-month.

Policymakers reiterated their pledge to bring inflation down to the central bank’s 2 percent target, and the latest data stream reinforced the impression that the U.S. economy was showing resilience.

Markets are all but certain that the FOMC will opt for a 25 basis point hike on Wednesday, bringing the federal funds target rate to a range of 5.25% to 5.5%. CME Group Fed Watch tool.

However, with inflation and the labor market now continuing to cool, Wednesday’s expected rate hike could mark the end of 16 months of almost constant monetary tightening.

Economists at Moody’s Investors Service said in a research note last week, “The Fed has signaled a willingness to raise rates again if necessary, but if labor market and inflation data for July and August provide more evidence that wage and inflation pressures have now receded to levels consistent with the Fed’s goals, the July hike could be the last – as markets are currently pricing in.”

“However, the FOMC will maintain a tight monetary policy stance to help moderate inflation amid continued weakness in demand.”

Steve Englander, global head of G10 FX research and North American macro strategy at Standard Chartered Bank, agreed, saying the debate going forward would revolve around guidance issued by the Fed. Over the past week, several analysts said policymakers would continue to be “data dependent” but pushed back against any talk of a near-term rate cut.

“There are good reasons to suggest that September should be skipped barring a sharp upside surprise in inflation, but the FOMC may be wary of giving dovish guidance that is dovish,” Englander said.

“In our view, the FOMC is like a weather forecaster who predicts a 30% chance of rain but biases the forecast in favor of rain as the impact of an erroneous sunny forecast is perceived to be greater than the impact of an erroneous rain forecast.”

European Central Bank

The euro area has also seen unexpected downward inflation recently, with consumer price inflation in the euro area hitting 5.5% in June, the lowest since January 2022. But core inflation remained stubbornly high at 5.4 percent, up slightly from the month, both figures still well above the central bank’s 2 percent target.

The European Central Bank raised its key interest rate by 25 basis points to 3.5% in June, unlike the Federal Reserve, which paused and continued a series of rate hikes beginning in July 2022.

Markets are pricing in a more than 99 percent chance of a further 25 basis point rate hike after Thursday’s ECB policy meeting, while major central bank data also kept a hawkish tone in line with their counterparts across the Atlantic, Refinitiv data showed.

ECB Chief Economist Philip Lane warned markets last month against rate cuts in the next two years.

Paul Hollingsworth, chief European economist at BNP Paribas, said that like the Fed, a quarter-percentage-point rate hike is all but booked, and the focus of Thursday’s ECB announcement will be the ECB’s Governing Council’s directive on the future path of policy rates.

“Compared to June, when President Lagarde said ‘we are likely to continue raising rates in July,’ we do not expect her to pre-commit to the Security Council another hike at the September meeting,” Hollingsworth said in a note last week.

“After all, recent comments suggest that even the hawks are not firmly convinced that a rate hike will come in September, let alone that there is broad consensus this month to signal the possibility of a rate hike.”

Given the lack of clear direction, Hollingsworth said traders will read between the lines of ECB communications to try to create a bias towards tightening, neutral or pause.

At its last meeting, the ECB’s Governing Council said that “future decisions will ensure that the ECB’s key interest rate is sufficiently tight to achieve a timely return of inflation to its medium-term target of 2 percent, and will remain at these levels as long as necessary.”

BNP Paribas expects this to remain the case, which Hollingsworth said represents an “implicit tilt towards further tightening” with “room to maneuver” in case upcoming inflation data disappoints.

“However, the message at the press conference may have been more subtle, suggesting that more may be needed, not more,” he added.

“Lagarde could also choose to reduce her focus on September, noting the possibility of a Fed-style ‘skip’, which would leave open the possibility of a rate hike at subsequent meetings.”

Bank of Japan

Far from talk of the last monetary tightening in the West, the question for Japan is when its central bank will be the last to tighten.

The Bank of Japan kept its short-term interest rate target at -0.1% in June, hoping to spur the world’s third-largest economy out of a long period of “stagflation” characterized by low inflation and sluggish growth since it first implemented negative rates in 2016. Policymakers also left the central bank’s yield curve control (YCC) policy unchanged.

However, Japan’s first-quarter economic growth was revised up sharply to 2.7% last month, while inflation remained above the Bank of Japan’s 2% target for the 15th straight month, rising 3.3% year-on-year in June. That sparked some early speculation that the Bank of Japan may finally be forced to start reversing its ultra-loose monetary policy, but markets still don’t see any changes to rates or the YCC in Friday’s announcement.

Yield curve control is usually a temporary measure in which the central bank targets long-term interest rates and then buys or sells government bonds at the levels needed to reach that rate.

Under Japan’s YCC policy, the central bank targets short-term interest rates at -0.1 percent and 10-year government bond yields at zero plus or minus 0.5 percent, aiming to maintain an inflation target of 2 percent.

Barclays noted on Friday that Japan’s output gap (the difference between actual and potential economic output) remained negative in the first quarter, while real wage growth remained negative and the outlook for inflation was uncertain. Economists at the Bank of England expect the central bank to drop the YCC at its October meeting, but say this week’s split vote could be important.

Christian Keller, head of economic research at Barclays, said: “We think the policy committee will reach a majority decision, with votes split between relatively hawkish members (Tamura, Takata) who emphasize the need for YCC revisions, neutral members including Governor Ueda, and dovish members in the reflation camp (Adachi, Noguchi).”

“In our view, this departure from the unanimous decision to maintain the YCC could stoke market expectations for future policy revisions. In this context, the July post-MPM press conference and August 7 opinion summary will take on particular importance.”