Central banks divided: inflation, rates and global divergences

Raising interest rates to combat inflation, which has remained sticky since Russia invaded Ukraine in 2022, has long been the main tactic adopted by central banks, as rising borrowing costs curb public and private spending, easing price pressures. However, rate hikes also threaten economic growth and have repercussions on government bond markets, at a time when long-term yields are already reaching new cyclical highs.

In the large economies of the United States, the Eurozone, the United Kingdom and Japan, the picture is currently heterogeneous, as the Fed, the European Central Bank, the Bank of England and the Bank of Japan each find themselves facing their own different dilemmas.

Aggressive tones

The annual symposium hosted by the Federal Reserve in Jackson Hole showed the growing divergence in how the world's central banks are believed to be addressing inflation and economic growth. In his speech on August 28, Fed President Kevin Warsh adopted an aggressive tone on inflation, fueling expectations of rising or, at least, not falling rates.

However, if on the one hand this has substantially changed the narrative on US monetary policy, on the other hand it has highlighted the growing divergence from other central banks in Europe, Japan and the rest of the world, which are also grappling with the fight against inflation, but with different abilities to use interest rates as their main weapon.

One way to try to predict future rate hikes, and their effect on asset prices, is to calculate the “neutral” rate, which would have neither a negative nor positive impact on the local economy. The reference range for this “nominal neutral” rate is highest in the UK and lowest in Japan, the US and Canada, as shown in the chart below.

This means Japan has the most leeway to raise rates without fear of hindering economic growth. The United States also has room for an increase, but the Eurozone, Australia and the United Kingdom risk driving interest rates too high and negatively impacting economic growth.

Inflation problems are not the same

Part of the reason for this divergence is that the drivers of inflation differ between the United States, the Eurozone and Japan, so central bank responses would produce different effects. In addition to threatening growth, rate hikes cause bond yields to rise, raising borrowing costs for governments, which are already grappling with growing budget deficits and record levels of public debt.

In the United States, inflationary pressures reflect tariffs, resilient demand and investments. The Fed has taken a more restrictive stance, while the US Treasury remains the most visible market operator through bond buybacks and market stabilization measures.

This interaction effectively offers the Fed the possibility of keeping rates at neutral levels while adopting an aggressive tone on inflation, without losing control of the long segment of the US Treasury yield curve. This reminds us of 'Operation Twist' (where the Fed buys long-term bonds).

The energy cost dilemma

In the Eurozone, inflation is mainly a price shock due to increases in imported energy prices caused by the conflict in the Middle East. The ECB can tighten monetary policy in line with its inflation mandate, but the absence of domestic drivers makes the economy more vulnerable to higher rates. We already saw this in 2008 and again in 2011, when the ECB raised rates in the midst of a commodity shock.

Japan appears to be in the best position – unlike the past 40 years – because inflation reflects structural reflation and domestic growth. The Bank of Japan can normalize rates without putting a brake on its economy. Furthermore, higher rates may increase the attractiveness of the yen, which is on a structurally bearish trend.

The potential repercussions are summarized in the table below.

Effects on stocks and bonds

Higher rates also impact asset values. Overall, risk assets (credit and equities) have held up well at higher rates over the past five years, largely because the second-order effects of inflation have been contained, and we continue to believe this narrative.

We recognize, however, that this optimistic scenario faces increasing obstacles as US exceptionalism wanes; at the same time, 'risk-free' rates can no longer be considered as such due to the explosion of public debt and the persistence of supply-side shocks linked to oil and tariffs.

Therefore, the short-term orientation for all central banks will be to proceed with synchronized tightening. However, in the medium term the outcomes in the three regions could be very different. The ECB could raise rates in response to the energy shock, but without the economic cushion we see in Japan or the United States. The Bank of Japan has further room to maneuver to raise rates without impacting the domestic economy.

The Fed, for its part, faces a high-pressure economy, and the short end of the US Treasury yield curve could remain sensitive to these pressures. Therefore, the US term premium is exposed to upward pressures; this suggests continued cooperation between the Fed and the Treasury to avoid losing control over longer-term rates.