The major central banks of the world are facing very different inflation challenges, and their interest rate policies reflect the divergence.
The United States has seen its headline inflation rate peak at 9% and decline to 4%, although its core inflation rate has been stickier and slower to recede. The Federal Reserve was also the first major central bank to raise rates to combat inflation, and it did so aggressively. Short-term rates went from near zero to 5% in record time. The progress on inflation in the U.S. suggests the Federal Reserve is at or very close to its peak interest rate.
Eurozone inflation peaked later and higher than in the U.S., in part due to the energy and electricity price surge associated with the Russian invasion of Ukraine in early 2022. Core inflation in Europe is also higher than in the U.S. The European Central Bank was behind the Federal Reserve in starting to raise rates and faces a more difficult inflation challenge. Policymakers in Europe have guided that rates need to go higher.
After several decades of no inflation and the persistence of a deflationary psychology, the Bank of Japan has welcomed the moderate inflation that has occurred over the last two years. Thus, the Bank of Japan has maintained its zero-rate policy as it assesses the future path of inflation and whether long-term inflation expectations are starting to rise.
China is in a very different position. Inflation is declining, as the country has been slower to rebound from its zero-COVID policy than many had hoped or expected. Consequently, the People’s Bank of China has lowered rates.
Facing different challenges, central banks are going their separate ways, which can make for more volatile exchange rate markets. More recently, the Japanese yen and Chinese yuan have seen some depreciation, given their more accommodating policies. Meanwhile, the euro has been settling into a trading range against the U.S. dollar, thanks to the mixed picture on inflation and the pace of rate increases.
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