Diverging central banks: ECB lifts rates again while Fed stands pat

Executive summary:

  • ECB opts for 25-bps rate increase at June meeting
  • U.S. core inflation for May matches expectations
  • U.S. recession still expected in 12-18 months

On the latest edition of Market Week in Review, Investment Strategy Analyst BeiChen Lin and Equity Manager Research Analyst Michelle Batargal discussed the diverging actions taken by the European Central Bank (ECB) and the U.S. Federal Reserve (Fed) at their recent policy meetings. They also chatted about the U.S. consumer price index (CPI) report for May and provided an update on U.S. recession risks.

ECB hikes key lending rate by 0.25%, hints at additional increases

Batargal and Lin opened their conversation with a look at the latest announcements on monetary policy by both the ECB and the Fed. Unlike the U.S. central bank, which decided to skip a rate increase at its June 13-14 meeting, the ECB delivered another 25-basis-point (bps) rate hike at its June meeting, Lin said. What’s more, at a press conference following the announcement, ECB President Christine Lagarde strongly hinted that additional rate increases are in the cards, he remarked.

Why? One of the main reasons is that inflation in Europe has remained very sticky, Lin explained, noting that ECB staff members actually revised their 2023 and 2024 projections for core inflation upward. In addition, the ECB kicked off its rate-hiking campaign a few months after the Fed did, he said, meaning that Europe’s central bank still has more ground to cover to reach a similarly restrictive level that will help lower inflation back to its target range of 2%.

In contrast, the Fed has tightened by more than 500 bps since March 2022, Lin noted, meaning that U.S. interest rates are already far into restrictive territory. “With rates so deeply restrictive, the Fed is hitting pause in order to assess the current situation, look at the incoming economic data and determine if it’s moving the needle enough toward price stability while simultaneously trying as best as possible to not disrupt economic growth,” he explained.

Lin stressed that when it comes to balancing inflation concerns with recession risks, the Fed will err on the side of bringing inflation under control first. “We saw evidence of this in Chair Jerome Powell’s June 14 press conference, where Powell signaled there could be more potential rate hikes in the future,” he remarked, adding that the central bank will probably spend the next few weeks assessing the current economic backdrop before making any decisions on future monetary policy.

U.S. core inflation tracks in line with expectations

Speaking of the latest trends in U.S. economic data, Lin noted that May’s CPI report was published by the Labor Department on June 13. The report showed that headline inflation fell to its lowest reading in two years, he said, while core inflation—which excludes the often-volatile food and energy sectors—tracked largely in line with expectations.

“On a month-over-month basis, core consumer prices climbed by 0.44%, with a fair amount of this increase tied to rising automobile prices,” Lin said, explaining that these prices tend to be a little more volatile. In a more promising development, core services excluding medical, shelter and transportation—a category that the Fed has been more worried about lately—showed signs of stabilizing a bit, he noted.

At the same time, however, the central bank remains very focused on returning core inflation rates back to their 2% target—and in order to do so, Fed officials have to make sure that the nation’s labor market is brought back into balance, Lin remarked. “This isn’t the case right now, as the U.S. jobs market remains very strong and resilient, with demand far outweighing supply,” he said, adding that the latest numbers from the Atlanta Fed’s wage tracker show nominal wage growth is still around 6%.

Ultimately, these levels—which are far above the 2% inflation target the Fed is seeking—explain why more rate hikes could be in store as soon as next month, Lin concluded.

U.S. recession outlook

Batargal asked Lin if any of this new information could change Russell Investments’ recession outlook. Lin responded that the investment strategist team’s outlook remains very similar to what it was earlier in June, with expectations for a recession in the U.S. and other developed markets in the next 12 to 18 months. He added that the team’s complete outlook will soon be available with the release of Russell Investments’ Q3 Global Market Outlook on June 27.

“With the benchmark S&P 500® Index closing north of 4400 on June 15, I know it can be hard for people to believe a recession may be on the horizon. However, a glance at several leading economic indicators shows that many are already pointing to signs of an impending economic slowdown,” Lin stated. For instance, he said that the U.S. manufacturing sector is already exhibiting signs of weakness, while temporary help employment—essentially, individuals working on a contract basis—has already started to peak.

With that, Lin added that not all of the data pertaining to the U.S. economy is always going to point in the same direction. In other words, there won’t necessarily be a linear path to an economic slowdown, with pockets of resilience possible along the way, he said. As proof, he pointed to U.S. consumer spending data from May, which came in unexpectedly strong. However, on balance, a comprehensive look through all the data points—coupled with the fact that the Fed has already tightened by over 500 bps in the past year-plus—means the U.S. is likely headed toward a recession, Lin said.

He emphasized, however, that a 2008-style recession is not expected. Rather, the next economic downturn is likely to be on the mild to moderate side, Lin stated. “With this in mind, I don’t think investors should panic. Think about how when you’re driving along the road and see a speed bump up ahead, you don’t get out of your car. Instead, you just buckle up a little tighter and go over the bump. The same logic applies here—if investors have a plan, stay disciplined and stick to their strategic beliefs, I believe they’ll be able to weather the economic storm just fine,” he concluded.

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