The European Central Bank (ECB) raised interest rates by 0.25 percentage points on Thursday last week, concerned about higher energy prices stemming from the war in the Middle East and aiming to curb a further price upswing. The ECB’s action has made it the first among its peers in the G7 economies to raise rates since the war broke out at the end of February. The bank said in a statement that the rising energy prices could lead to broader increases in food and services prices and affect the eurozone’s medium-term economic outlook.
While it was the bank’s first rate hike in 33 months and followed an extended easing phase since June last year, it remains to be seen if the move signals the start of a tightening cycle, as the ECB said in the statement that it would continue to “follow a data-dependent and meeting-by-meeting approach.”
It seemed appropriate and reflected the ECB’s intention to stay ahead of the curve and maintain its credibility, as the risks of inaction or falling behind usually increase inflation expectations and outweigh the impact of moderate rate hikes.
In the US, the US Federal Open Market Committee (FOMC) meeting today and tomorrow puts new Fed Chairman Kevin Warsh’s monetary policy to the test, after the latest data showed a stronger-than-expected jump of 172,000 in US non-farm payrolls last month, along with higher consumer inflation above 4 percent last month for the first time in three years and the University of Michigan’s consumer sentiment index rebounding this month.
All eyes are on what decision the Fed makes at its first FOMC meeting under Warsh. With US employment indicators strengthening and inflation resurging, expectations for a rate cut by the Fed appear to have weakened. Analysts at Goldman Sachs Group Inc have penciled two Fed cuts by March next year, but last week pushed the cuts to June and December next year. However, as core inflation, excluding volatile energy and food prices, did not exceed analysts’ forecasts and there were no signs that price pressures were spreading, a Fed rate hike looks unlikely in the near term.
As a result, this week’s FOMC meeting might be more about how Warsh is reshaping the Fed’s monetary policy decisionmaking process, as he leads an increasingly divided central bank caught between combating persistent inflation and managing external political pressures. As Warsh had criticized the Fed’s operating model during his Senate confirmation hearing in April, the immediate attention is on whether he prioritizes internal structural reforms over rate projections — such as reducing forward guidance through the “dot plot” chart, presenting plans to shrink the Fed’s balance sheet, or limiting communication during the post-meeting press conference, or even canceling the conference outright.
Meanwhile, several other central banks from Tokyo to London and Zurich and from Taipei to Manila and Jakarta are slated to renew their assessments of domestic and global conditions as monetary policymakers meet this week, with the conflict between the US and Iran having dragged on for close to four months. While any change in language on inflation outlook would be notable, economists have been unanimous in saying that elevated energy prices remain the key factor sustaining policymakers’ hawkish policy bias.
Even as central banks decide to keep rates unchanged, their inaction does not mean they are satisfied with the situation; rather, it might indicate that policymakers await more economic data due to rising uncertainty. This creates a catch-22 situation for central banks in their communication with the public: If they overemphasize uncertainty, it could obscure public understanding of policymakers’ economic assessment and erode people’s trust in their institutional mandates. However, if they are assertive about economic trends despite difficulties in quantifying the impacts of developments and their claims prove wrong, they risk their credibility.
To address this delicate situation, the Bank for International Settlements gave its answers in a March report, saying central banks must balance these two extremes amid high uncertainty, while offering various communication strategies to maintain their effectiveness and credibility. Certainly, avoiding overconfidence, preventing ambiguity and ensuring transparency are all important for central banks to convey their economic outlooks without promising false precision. However, communication is not the only problem; the real issue lies in the dynamic and unpredictable evolution of events, especially those beyond central banks’ economic models, and it is a tightrope walk for central banks.
