Central Bank Surprises

After more than one year since central banks embarked upon their aggressive tightening cycles, they now seem to be closer to the end (or maybe even there). Inflation has generally moderated, but remains elevated and far from their targets, while the labor market is still tight in many countries despite some signs of cooling.

Given the massive amount of tightening already delivered and its lagging nature, policymakers try to assess when to stop, but high inflation and strong employment call for restrictive stance, creating an uncertain monetary outlook.

Around a month ago, I had written about how central banks are all over the place and the three new policy decisions since, are a testament to that. The central banks of Canada and Australia this week and the one of New Zealand in late-May, all went against market expectations.

Bank of Canada

The BoC was the first major central bank to hit the pause button in March, when it kept rates at 4.5%. Inflation had been decelerating, which allowed it to do that and to stay in the sidelines for the next two meetings. However, the most recent CPI data showed that headline inflation accelerated 4.4% y/y in April, in the first increase in nearly a year and June's forty-years peak.

The Bank of Canada changed tack and restarted its rate hiking cycle on Wednesday, surprising markets, which anticipated a hold. It raised rates by 25 basis points to 4.75% and the highest since 2001, judging that policy was "not sufficiently restrictive" to bring inflation back to the 2% target. ^[1]

According to April's forecast, officials expect this to happen gradually by the end of the next year ^[2], but today officials noted that "concerns have increased" about the CPI sticking "materially above" target. Adding to the uncertain outlook, they did not offer forward guidance as to their next steps, reiterating simply their "commitment to restoring price stability for Canadians".

Reserve Bank of Australia

The RBA had paused its year-long tightening plan in April, in order to assess the data and the cumulative effect of its actions. This did not last long though since it raised rates again in May and doubled down this week, with another 0.25% increase, with both moves going against baseline market expectations. ^[3]

Inflation eased to 7% y/y in the first quarter and although policymakers believe it has "passed its peak", they view it as "still too high", warning that "some time" will be needed before falling to the 2-3% target. The central bank kept more policy firming in play, saying that "some further tightening" in monetary policy "may be required" for bringing inflation down to target in a "reasonable timeframe".

Reserve Bank of New Zealand

The RBNZ has been at the forefront of monetary tightening, having started raising rates all the way back in October 2021. In its latest meeting in late-May, it slowed the pace with a 0.25% increase in rates, having now delivered 525 basis points worth of hikes since, since the 2021 lift-off. ^[4]

What came as a surprise though, was the fact that policymakers view the current 5.5% as the terminal rate, according to their projections ^[5]. This is a pivotal moment, for a central bank that has been consistently hawkish. It is also on a different tune compared to some of its major counterparts, such as the BoC and the RBA, which restarted hiking after a pause.

What's Next

Now focus shifts on the US Fed and the European Central Banks, who announce their policy decision next week. The ECB has been consistently aggressive and diverging from its US counterpart, as it has hinted to more rate increases.

Things are less certain around the Fed and as to whether to hike or pause. Inflation remains far from the 2% target and the labor market is very tight calling for sustained restrictive stance. On the other hand, the central bank had hinted at a pause in the last meeting and last week two voters argued in favor of skipping a hike this month.

Market expectations adjusted accordingly, as CME's FedWatch Tool currently assigns the highest probability to rates staying at 5.25% in June, but still prices in another increase after that. ^[6]