Core inflation is widely expected to fall in the US and Europe in 2H22 as consumer goods shortages moderate, pandemic constraints on labour supply fade and growth rates normalise. This should allow central banks to gradually normalise monetary policy, with limited impacts on growth. Fitch expects the Fed to raise interest rates by 100bp in 2022 and a further 100bp in 2023, the Bank of England (BOE) to hike rates by a further 75bp this year and 50bp in 2023, with the ECB increasing rates by 20bp next year.
However, recent inflation outturns have been higher than expected and the price outlook is uncertain. Inflation is a dynamic process and can be self-reinforcing. Various factors could keep core inflation high throughout 2022. Global energy price shocks related to the Russia-Ukraine crisis exacerbate risks.
If core inflation remains high and inflation expectations rise the Fed and the BOE could be left with no choice but to quickly move rates to neutral or restrictive levels. This could entail the Fed Funds rate rising to 3% by the end of this year.
A more abrupt adjustment path could take a big toll on GDP including through tighter credit conditions and a sharp rise in long-term US bond yields. US GDP growth could fall to 0.5% or below in 2023 in such a scenario, compared with Fitch’s baseline forecast of 1.9%.
The risk of a more abrupt policy adjustment from the ECB is lower, but if eurozone inflation were to remain high quantitative easing could be wound up and interest rates increased this year.
