Just A Hike, Skip, And A Cut

In a tale of three central banks, the People's Bank of China, the US Federal Reserve (Fed), and the European Central Bank (ECB) all made different interest rate decisions this week, with one cutting, one pausing, and one hiking borrowing costs.

🕰 Recap

• New data out this week showed US inflation slowed more than expected in May to hit its lowest level in more than two years.
• That helped support the case for Fed officials to pause their run of aggressive interest-rate hikes, and that’s exactly what they did at their meeting on Wednesday.
• In contrast to the Fed, the ECB went ahead with a widely expected rate hike on Thursday and signaled that it’s not thinking about pausing.
• China’s central bank, on the other hand, cut two key interest rates this week after new data reinforced concerns over a stalling post-Covid recovery in the world’s second-biggest economy.

✍️ Connecting The Dots

What a week it’s been for central banks. Released just a day before the Fed’s announcement, the latest US inflation report showed that overall consumer prices were 4% higher in May compared to the same time last year – a big step down from the 4.9% jump registered in April and the lowest increase since March 2021. Core inflation, which strips out more volatile prices like food and energy, also decelerated last month.

On the heels of the better-than-expected data, the Fed decided to pause its rate-hiking run following ten consecutive increases since March 2022, but signaled that it would likely put its boots back on at some point soon. In fact, most policymakers are projecting that the Fed will need to do two more quarter-point increases this year to cool the country’s still-too-hot inflation – a move that would lift its key interest rate to about 5.6%. Most of the central bankers forecast that there will be interest-rate cuts next year, with the key rate sliding to 4.6% in 2024, and 3.4% in 2025. But both estimates are above where they were in March, suggesting that the Fed intends to keep monetary policy tighter for longer to tame inflation once and for all.

The ECB, on the other hand, went ahead with a widely expected quarter-point hike on Thursday, taking its main deposit rate to 3.5% – the highest level since 2001. And unlike its American counterpart, the ECB signaled that it’s not even thinking about pausing, instead dropping not-so-subtle hints about another hike in July. Finally, in sharp contrast to them both, China’s central bank slashed its short-term and medium-term interest rates by 0.1 percentage points each this week, to 1.9% and 2.65%, respectively, marking the country’s first rate cuts since August 2022.

🥡 Takeaways

1. Trying to wake up the economy.

The move by China’s central bank caught many investors off guard: it reveals that officials are growing more worried about sluggish economic growth and feel the need to intensify their efforts to stimulate the recovery. But while rate cuts may help sentiment in the short term, economists say more needs to be done to lift confidence and get businesses to invest and consumers to spend. And that’s because cheaper rates on loans don’t amount to much if companies and people don’t want to borrow in the first place. That’s why many expect the government to eventually announce a broad package of stimulus measures to get demand going again, including a big focus on propping up the country’s ailing property sector, which, together with related sectors, makes up around one-fifth of the economy.

2. Towering interest rates cast dark shadows.

Sharply higher rates are putting the screws to risky companies that have loaded up on leveraged loans – that is, debt with floating borrowing costs that move with prevailing interest rates. By the end of May, the US junk loan market had already seen 18 debt defaults, totaling $21 billion, this year – that’s more in total number and total value than it saw in 2021 and 2022 combined, according to Goldman Sachs. Things aren’t looking up either, with analysts expecting defaults to rise further as interest rates stay higher for longer and as slowing economic growth further squeezes corporate earnings.

🎯 Also On Our Radar

El Niño – the often tumultuous weather phenomenon that results in wetter conditions in the southern part of the US and drier conditions in many parts of the tropics – is set to return for the first time in almost four years, and could put additional stress on an already fragile world economy. It could disrupt crop yields, stoke commodity-price inflation, shrink economic growth, strain power grids, upset supply chains, and more. All in all, coupled with more extreme weather due to rapid climate change, the world could be on the brink of experiencing the most expensive El Niño cycle since weather experts started recording such events.