A preview of the Fed’s and the ECB’s July meetings

Today, with inflation so far from both central banks’ 2% objectives, it is the focus of policy makers’ attention. In contrast, the outlook for economic activity plays little role in the policy decisions. Indeed, both central banks may desire growth to slow as it is a determinant of future inflation.

The figures below show just how far from 2% headline inflation (inflation computed using all the components of the CPI) and core inflation (inflation disregarding the volatile food and energy components¹) stand.

Chart 1a. US CPI inflation

Chart 1b. Eurozone HICP inflation

Sources: FRED and Eurostat, data as of 18 July 2023.

The figures illustrate that the inflation problem in the eurozone is more adverse than in the US. The peak rate of inflation was higher in the eurozone (10.6%) than in the US (8.9%). The peak in the eurozone is also more recent (October 2022) than in the US (June 2022). Furthermore, headline inflation in June was higher in the eurozone than in the US (5.5% vs 3.1%) as was core inflation (5.4% vs 4.9%).² Finally, while core inflation rose in the eurozone in June from 5.3% to 5.4%, it fell sharply in the US from 5.3% to 4.8%.

Central banks attach greater focus to core inflation than headline inflation since they view the latter as being subject to temporary erratic swings arising from disturbances to energy and food prices. While headline inflation has fallen sharply in both economies in response to falling energy prices, core inflation has fallen much less, if at all. Excluding its recent decline in the US in June, core inflation has fluctuated between 5.3% and 5.7% in the US and eurozone since December 2022.

With little clear sign of core inflation declining, the Fed’s Federal Open Market Committee and the ECB’s Governing Council are both expected to raise interest rates this month.³ Market pricing suggests that the perceived probability of an interest rate increase is about 95% in both cases.

Market pricing for December suggests that little change in policy is expected during the autumn. While market participants view the ECB as being most likely to raise interest rates one more time later this year, the Fed is expected to stay put. Of course, in both cases market participants attach some probability to rates being above or below the most likely outcome.⁴

Chart 2a. Probability distribution, July 2023

Chart 2b. Probability distribution, Dec 2023

Source: Refinitiv, data as of 17 July 2023.

In conclusion, with core inflation stuck significantly above 2%, market participants expect the Fed and the ECB both to raise rates this month, and the ECB to raise rates once more in the autumn. How policy will evolve in practice will depend on the behaviour of core inflation. If it were to fall more rapidly than is currently expected, the turn in monetary policy could come earlier than expected. And if it were to continue to fluctuate at current levels, further interest rate increases become more likely.

¹ For the eurozone measure, the prices of alcohol and tobacco are disregarded too.
² The data for the eurozone for June 2023 are flash estimates.
³ While the ECB sets interest rates at point (currently 3.5%), the Fed uses a range for its policy rate (currently 5-5.25%). The graph refers to the lower end of that range.
⁴ Interestingly, the distribution is symmetric, implying that they attach an equal likelihood to interest rates being at a level above or below the most likely outcome.