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Neither the Fed nor the ECB have fundamentally changed course in the past two months, but they have clearly repositioned themselves: Both central banks have practically ruled out further interest rate hikes, meaning that they believe they can push the inflation rate down to the targeted level of 2% with the current restrictive orientation of their monetary policy. Both central banks are holding out the prospect of interest rate cuts this year, but are dampening the markets' overly high expectations. Fed Chairman Powell made it clear this week that interest rate cuts in March were "not the most likely scenario" and ECB Chairman Lagarde claimed that it was still "too early for the ECB Governing Council to discuss interest rate cuts".
Looking at the fundamental environment, the central banks' caution seems justified: Inflation is continuing to fall and inflation rates close to the 2% mark are likely to be achieved this year, particularly in the eurozone. At the same time, however, there are still significant risks: Prices, excluding the volatile components of energy and food, continue to rise too quickly. Extrapolated for the year as a whole, the current figures still suggest an inflation rate of more than 3% in both the USA and the eurozone. It is therefore not yet certain that the 2 percent target will be achieved. In this situation, it is always better for central banks to use the current data situation to carefully analyze whether price momentum is actually weakening as desired, instead of rushing ahead and lowering interest rates and thus possibly encouraging a renewed rise in price momentum.
Risks for both central banks lie in wage dynamics: the Congressional Budget Office has calculated that the inflation-neutral unemployment rate in the US is 4.4%, 0.7 percentage points higher than at present. This means that either the unemployment rate will remain low, as expected by the Fed, resulting in significant risks for a recovery in wage growth and thus inflation, or unemployment will have to rise, which, according to all previous experience, would lead to a recession in the US economy. At present, the US economy is still booming, which speaks more in favor of the first scenario than the second, at least for the time being. In the eurozone, the ECB says it is monitoring wage trends very closely: In the current environment of increased scarcity on the labor market, stronger wage increases are conceivable, which would favor a rebound in inflation or at least a persistence at a level of more than 2 percent. From a German perspective, this is countered by the ongoing economic weakness, which is now also making itself felt on the labor market. However, despite the stagnating economy, strikes for substantial wage increases are also on the rise in Germany, and Germany is not representative of the eurozone.
Central banks also have to reckon with external risks: An escalation of the crisis in the Middle East resulting in drastically rising oil prices remains a valid risk scenario. Although interest rate hikes would not be an appropriate response to such an external shock, the risk scenario in itself also suggests a cautious approach by central banks.
There are good reasons to assume that the announced interest rate cuts will come later and that there will be fewer downward steps overall than many market participants currently expect. It would only be plausible for the Fed to make six interest rate cuts by the end of the year if the US economy were to enter a recession in the second half of the year. This would not only allow the Fed to intervene more forcefully, but would actually make it necessary.
