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Fed and ECB likely to remain on hawkish track as inflation is still well above targets

The US Federal Reserve raised interest rates by 25 basis points in its July policy meeting, in line with expectations and the European Central Bank is widely expected to deliver another 0.25% hike today, with both central banks pointing to still high inflation and leaving door open for further hikes in September.

The US central bank raised interest rates for the eleventh time in twelve policy meetings during past year, with the latest action on Wednesday, pushing borrowing cost to 5.25%/5.50%, the highest since recession in 2007/2008.

Also, current tightening cycle marked the fastest and the strongest rise in interest rates in over two decades, as Fed was fighting with sharply rising inflation which hit the highest in over 40 years.

Although the US policymakers signaled that tightening cycle is nearing its end, due to significant drop in consumer prices, they remain cautious and will continue to closely watch economic data and base their decisions in the near future on the economic conditions at each central bank’s meeting.

Fed Chair Powell did not significantly change his rhetoric in past few meetings and said that inflation is still well above the target, adding that the economy needs to slow more and labor market to weaken, to push inflation to Fed’s 2% target.

Recent economic data signal that the US economy has so far proved to be resilient to high borrowing cost and the labor market remains tight, which leaves the central bank some space for more hikes.

The Fed needs to balance between requirement to slow the economy more and push inflation to target and threats of too strong slowdown which could push the economy into recession.

Powell pointed to easing of inflation but also to the pace of economic growth which is still above Fed’s estimated trend rate, unemployment at lows and strong job growth, which all need to slow further to prompt the central bank to pause and eventually end hiking cycle.

He added that reaching all these targets will cause some economic losses, inevitable consequences in the process of fully restoring price stability.

Markets see ECB’s July rate hike as done deal, which will mark the 9th straight raise in borrowing cost since the central bank entered the phase of fast hiking in order to bring record inflation under control.

Bets for another hike by 25 basis points in September are rising, as inflation in the Euro bloc is still 2.5 times above the target and is coming down too slowly, with expectations that it will not reach 2% target until 2025.

The main problem for the ECB is underlying inflation which is holding near historic highs and further acceleration cannot be ruled out, with still tight labor market adding to concerns.

On the other hand, growing evidence of economic downturn, mainly caused by high borrowing cost, as the ECB raised interest rates to 4.00% so far and is about to add 0.25% today, marks strong and opposite force which pressures the ECB.

ECB’s policymakers will remain cautious and balance between current requirements and possible consequences, as the central bank adopted rhetoric similar to Fed’s and signal that their future action will be fata-dependent and made on meeting to meeting basis.

However, we are unlikely to hear something new from ECB President Lagarde today, as the policymakers will continue to walk over the thin ice in attempts to eventually bring inflation under control, but to try to avoid pushing the economy into recession again.