• Central banks have little room for error as they try to control inflation and ward off recession.
  • The Federal Reserve will likely be aggressive in fighting inflation but is more exposed to potential policy error than the European Central Bank.
  • In such an uncertain macroeconomic environment, it will be important for long-term investors to remain disciplined, keep their strategic goals in mind and stay the course.

 

Commentary by Jumana Saleheen, Ph.D., Vanguard European chief economist

Central banks have an unenviable challenge in the months ahead: trying to gain control of inflation without choking off economic growth. To succeed, they’ll need to raise interest rates to just the right level. Overshoot with too-restrictive policy, and they risk inviting recession. Undershoot, and they put their hard-earned credibility at risk by letting inflation fester.

Three factors will determine whether central banks can navigate a soft landing of continued growth with prices rising at acceptable levels, or whether they miss an uncomfortably short runway:

  • The pace of rate hikes required for central banks to assert their inflation-fighting credibility.
  • How much wage and inflation expectations rise in defiance of that credibility.
  • The incidence of additional unanticipated shocks to supply or demand.

Whether central banks succeed in delivering a soft landing will depend in part on how high they raise rates above the neutral rate, and how long they keep them there1.

Market policy rate expectations reflect a tale of two regions

Notes: Market expectations for central bank policy rates at a given time are represented by one-month forward swap rates. US swaps are based on published overnight federal funds rate indexes. Euro area swaps are based on the published euro overnight index average. Neutral rate ranges are Vanguard estimates. Estimates of the neutral rate are determined by long-term economic factors and are subject to a wide band of statistical uncertainty. Estimates of the nominal neutral rate assume inflation of 2% in the US and 1.8% in the euro area.
Sources: Vanguard analysis using data from Bloomberg, as at 27 April 2022.

Market expectations of the terminal interest rate—the highest point in a rate-hiking cycle—have increased significantly since March. However, central bank challenges vary by region, and differences are readily apparent when comparing the United States with the euro area.

In the US, where headline inflation has soared to 8.5%, markets are pricing in a terminal rate of 3.5% by mid-2023. This likely reflects the expectation that the Fed will be aggressive in fighting inflation amid a tight labour market.

The chart also highlights the Fed’s exposure to potential policy error. Policy rates above neutral will be effective in fighting inflation precisely because they restrict economic activity—which increases the risk of recession. (An initial estimate of first-quarter US GDP showed an unexpected economic contraction. This exemplifies the challenging signals that the Fed may encounter in the months ahead.)

Inflation dynamics support lower euro area policy rates

Notes: Core inflation excludes volatile food and energy prices and is considered a better indicator of persistent inflation.
Sources: US Bureau of Labor Statistics, Eurostat and Bloomberg, as at 27 April 2022.

Markets in the euro area, meanwhile, anticipate that the European Central Bank (ECB) will raise interest rates more slowly toward the neutral rate.

Euro area headline inflation rose to 7.4% in March. More than half the latest surge was attributable to energy prices, a component less likely to translate into higher persistent inflation. Inflation in the US has been more broad-based—and thus more likely to persist—with only around a quarter recently attributable to energy prices. Moreover, the pace at which wage and inflation expectations could rise in defiance of central bank credibility appears higher in the US compared with the euro area.

Unanticipated shocks matter to policy rates, too

The path of interest rates over the next 12 months is not predetermined. It will depend on forthcoming data and unanticipated shocks. A further round of disruptions to supply—owing, for instance, to the spread of the Covid-19 Omicron variant in China or restrictions on the flow of natural gas between Russia and Europe—would likely stoke global inflation.

Uncertainty surrounding Russia’s invasion of Ukraine is a more immediate concern than inflation in the euro area, given the region’s proximity to the conflict. Consumer confidence is down. Any hints of weakness in forthcoming GDP readings will likely become part of the ECB’s rate-setting calculus.

We believe that a soft landing in the US is possible, but more than that, we believe the Fed will do whatever it takes to bring inflation under control.

Jumana Saleheen, Vanguard European chief economist

Central bank credibility benefits businesses and households

Inflation has reached levels that many parts of the developed world haven’t seen for 30 to 40 years. That makes the current bout of fast-rising prices a crucial test for central banks, some of which started targeting inflation in the early 1990s.

We believe that a soft landing in the US is possible, but more than that, we believe the Fed will do whatever it takes to bring inflation under control. When all is said and done, inflation back at central banks’ 2% targets will benefit businesses and households alike. Low and stable inflation engenders the confidence that economies need to thrive.

 

1 The neutral rate is the level at which policy interest rates would neither stimulate nor restrict an economy. 

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Important information

For professional investors only (as defined under the MiFID II Directive) investing for their own account (including management companies (fund of funds) and professional clients investing on behalf of their discretionary clients). In Switzerland for professional investors only. Not to be distributed to the public.

The information contained in this article is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.  The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.

Issued in EEA by Vanguard Group (Ireland) Limited which is regulated in Ireland by the Central Bank of Ireland.

Issued in Switzerland by Vanguard Investments Switzerland GmbH.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2022 Vanguard Group (Ireland) Limited. All rights reserved.
© 2022 Vanguard Investments Switzerland GmbH. All rights reserved.
© 2022 Vanguard Asset Management, Limited. All rights reserved.