Central Banks on the Verge of Panic Over Inflation | Daily Market Analysis

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To say that central banks are panicking would probably be an exaggeration, but not that much.

Consensus forecasts for the U.S. consumer price index (CPI) were wrong: the figure was up 0.1% from the previous month, while economists had forecast a decline. And while analysts had previously assumed that the Federal Reserve (Fed) would raise interest rates by 50-75 basis points (bps) this week, they now expect at least a 75 bps increase, with expectations of a full percentage point increase intensifying.

The increase in the overall CPI has only been so small because of the sharp drop in energy prices. Closely monitored core inflation, which excludes such pesky volatile categories as food and energy, was 0.6% monthly.

Investors now believe that the Fed will continue to raise interest rates until it can demonstrate that it controls inflation.

With a 75 bps hike this week, the Fed's target range for the federal funds rate will reach 3.0-3.25%, and futures now point to the likelihood of a rate hike above 4% by year-end, which implies further strong hikes at the two remaining Federal Open Market Committee (FOMC) meetings in early November and mid-December.

The Bank for International Settlements (BIS), commonly regarded as the central bank of central banks, expressed its opinion Monday in support of higher rates in the U.S. and other regions, even though they pose a threat of recession.

BIS chief economist Claudio Borio urged central banks to continue to actively raise interest rates. "Acting aggressively early usually reduces the likelihood of a hard landing," he said in the BIS Quarterly Economic Review.

Philip Lane, a chief economist at the European Central Bank (ECB), said last week that further key rate hikes were needed after shocking markets with a 75-bp increase earlier this month. Europe is suffering from inflation even more than the U.S. - the region's worsening energy crisis could cripple the economy and cause serious hardship for households.

Lane has been among those who have ignored the threat of inflation for months, so his admission that further rate hikes are necessary is an important signal.

The Fed began raising interest rates early and is doing so more aggressively, leaving other central banks in a catch-up role, with the Fed's rate hikes causing the dollar to strengthen sharply in the foreign exchange market. The rise of the dollar exacerbates inflation in other countries because the lion's share of international trade is settled in U.S. currency. When other currencies fall against the dollar, imports from the countries concerned become more expensive.

Major currencies such as the euro, the pound sterling, and the Japanese yen are now falling against the dollar, putting pressure on the central banks of the countries concerned. Even the Chinese currency has fallen below the threshold with the dollar rising above 7 yuan last week. The dollar index, which reflects the value of the U.S. currency against other major currencies, is up 14% this year.

The chart above shows the DXY growth within 2022

Meanwhile, the topic of quantitative tightening is getting more and more attention. Central banks are reinvesting less and less of the proceeds of bond redemptions, taking liquidity out of the financial system. The Fed, which has a balance sheet of $9 trillion, has been reducing reinvestments by $47.5 billion a month since June, and that figure will be raised to $95 billion this month.

The ECB is expected to start reducing its €8 trillion balance sheet. The ECB also lags behind the Fed on this aspect. ECB President Christine Lagarde said at the last meeting that it would be premature to discuss quantitative easing, but the pressure is building and the central bank is expected to bring up the subject at least for discussion at the October Governing Council meeting.

Meanwhile, the Bank of England is increasingly criticized for being too slow in responding to inflation. The Monetary Policy Committee postponed its scheduled meeting last week due to mourning the death of Queen Elizabeth II. This week, the regulator is expected to raise the bank rate by at least 50 bps, with some analysts even predicting a 75 bps increase.