The hawkish rhetoric out of European Central Bank Chair Christine Lagarde following her 25 basis-point rate hike on Thursday is indicative of what we expect to hear from many global central bankers whether they hike rates or not.
We have long made the case about a regime change in inflation and interest rates, and we now think that a consensus is building among major central banks that it is time to nip inflation in the bud following a period of looking through what many thought were transitory shocks.
This week we get policy decisions from the Bank of England, Federal Reserve and Bank of Japan that will lead to a further resetting of prices across asset classes and in most cases result in a rise in the cost of doing business.
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The Bank of England
RSM U.K. economist Thomas Pugh expects that the Bank of England will not follow the ECB in raising rates next week, but that the prospect of a synchronized global tightening cycle is growing.
The Bank is almost certain to leave the Bank Rate unchanged at 3.75% when the Monetary Policy Committee meets next week (17 September). The focus will instead be on the vote and the tone of the minutes.
The recent rise in energy and other commodity prices makes the discussion of rate cuts at the August meeting look premature and should give the minutes a more hawkish tinge. Even so, the outcome is another 6–3 vote to hold, with Huw Pill, Megan Greene and Catherine Mann again backing a 25bp increase. We also expect the annual pace of quantitative tightening (QT) to fall to around £50bn.
The MPC has maintained its wait-and-see approach since the start of the war, and we see little chance of a change next week. CPI inflation rose to 2.9% in July, but services inflation eased from 3.6% to 3.4%. Crucially, there is still no evidence of second-round effects. Wage pressures are gradually easing, private-sector regular pay growth is back at rates consistent with the inflation target, and the labor market continues to soften. Payrolled employment fell by 78,000 in the year to June, while vacancies remain well below their post-pandemic peak. As Andrew Bailey put it, “the process of underlying disinflation that was intact prior to the conflict remains in train.” The surge in gilt yields has also tightened financial conditions, making some of the Bank’s work for it. Together, these factors give the Committee enough cover to hold rates next week.
The problem is that the energy shock is becoming harder to look through. Oil is back above $100pb, while natural gas prices have risen by almost 50% since the late-July meeting, putting them close to the Bank’s adverse scenario. Higher energy prices will lift headline inflation over the coming months. We now expect inflation to peak at almost 4% in early 2027, only slightly below the 4.5% peak in that scenario.
The bigger risk is that the shock is now large and persistent enough to feed into wages, firms’ pricing decisions, and inflation expectations. That is where the MPC would need to respond.
Federal Reserve
Federal Reserve officials talked their way into a corner on hiking rates at the central bank’s Jackson Hole conference in August, and the recent inflation data for producers and consumers reduced space around those decisions.
We expect a 25 basis-point hike at the September meeting and two more hikes over the next year. to put inflation on a credible path back to the central bank’s 2% target.
Given that oil and distillate prices have meaningfully accelerated and are likely to be passed downstream to consumers, the combined Producer Price Index and Consumer Price Index data for August demands action out of the Federal Reserve.
The war-induced energy shock, tariffs and the AI build-out are all pushing prices higher.
But the normal course of action for the Fed in supply shocks like these is to view them as temporary and to look past them. So why is this time different?
The three supply shocks have endured long enough that it is no longer appropriate to identify them as transitory.
Businesses are no longer absorbing the higher gas, diesel and jet fuel prices, and accepting lower margins. Instead, they are passing along the higher costs to consumers. This dynamic is evident in the rising cost of groceries and everything touched by transportation and deliveries.
To be clear: The Fed should not be chasing volatile energy prices. That is not why we think the Fed should and will hike rates.
What was thought to be a short-term conflict in Iran has turned into a protracted standoff, which now requires a rational policy response from the Federal Reserve.
The Fed needs to remove the three rate cuts from last year and slow an economy that is likely to grow well above trend in the current quarter. Nominal GDP was above 6% in the second quarter, the deficit to GDP ratio is above 6%, the economy resides at or near full employment, and corporate profits are at a record.
By slowing the economy, the central bank will force those price increases that are now flooding into household balance sheets back onto corporate balance sheets via margin compression.
Granted, this decision on rates is a difficult call and is truly a coin flip. But for the Fed not to hike rates at its next meeting would be a blow to its own credibility given clear pricing dynamics following comments by Fed Chair Kevin Warsh at Jackson Hole and other rhetoric by the central bank’s hawks and doves.
Bank of Japan
The Bank of Japan, following an unexpected joint intervention with the U.S. Treasury to prop up the yen, is now likely to hike rates, which only two months ago was unlikely given domestic political dynamics.
But now, following the intervention and rhetoric out of the Takaichi administration, it would appear that a rate hike is on the way with more than one a distinct possibility.
And with that, conditions are coalescing for another unwind of the globally important carry trade that facilitates capital flows from east to west. Such an unwinding could prompt a further repricing of risk assets in the U.S. and elsewhere.
