Inflation strikes again: Are global interest rates on the way to a renewed jump?

Ofer Klein, head of the Economics and Research Department at Harel Insurance and Finance, conducted a weekly economic review in which he touched upon interest rate decisions around the world, the US employment report, the effects of investments in artificial intelligence on the local economy, and inflation in Australia.

"The week of interest rate decisions at the world's major central banks (Eurozone, USA, UK, and Japan) ended without changes to the interest rate. But the lack of change does not indicate neutrality; in most cases, the assessment that this is a wait before a rate hike has even strengthened. The wait for action in the Middle East did not add optimism either. The renewed damage to tanker traffic has brought back the fear of a prolonged disruption in energy routes. Even if a lull has returned in recent days, the uncertainty in oil and shipping prices is expected to make the inflation decline process difficult.

In opposite directions - interest rate decision in India and Brazil tomorrow (Wednesday): The rise in oil prices and India's high dependence on energy product imports from the Gulf have pushed inflation above the target to 4.4%. The rise in inflation and future risks, alongside signs of disruptions in growth against the backdrop of increasing protests against the government, are expected to lead the central bank in India to leave the interest rate unchanged at 5.25%.

The main interest will be the question of whether the bank will signal that in light of recent developments and the weakness in the currency, it is considering the possibility of a rate hike. On the other hand, the central bank in Brazil cooled expectations in the previous decision that it would continue with interest rate cuts, against the backdrop of the jump in energy prices, the tight labor market, and the expansionary fiscal policy. At the same time, the surprising decline in inflation in June alongside the fact that the interest rate is still very high (14.25%) may allow the bank to reduce the interest rate by another quarter of a percentage point in the upcoming decision tomorrow.

In the USA, the employment report for July is expected to be the main event of the week: The support of some committee members for a rate hike now continued to push long-term yields upward. In the USA, the interest rate remained unchanged again at 3.5%–3.75%, in accordance with our assessment, although the markets gave a probability of about 35% for a hike.

The committee's announcement was more hawkish than expected, as three members supported a rate hike and emphasized that inflation has been above the target for more than five years, while the economy and the labor market continue to demonstrate resilience. On the other hand, a majority of nine members (including the Chairman) supported leaving the interest rate unchanged.

Alongside the hawkish decision, the Chairman's words were more balanced. He did repeat the commitment to a 2% inflation target and noted that the economy continues to demonstrate resilience. However, he referred to price pressures stemming from artificial intelligence that may be temporary, and added that the rise in yields since the previous decision has already effectively tightened financial conditions and is doing some of the work for the central bank.

He refrained from providing forward guidance and clarified that the Fed prefers to allow markets to respond to data instead of relying on a predetermined interest rate path. According to media reports, as part of his policy to change the way decisions are made and presented to the public, he is even considering reducing the number of interest rate decisions (from 8 currently).

The lack of forward guidance, alongside the rise in energy prices and the support of some committee members for a rate hike, have led to the financial markets still pricing in a very high probability of a rate hike as early as mid-September. However, in our central scenario, we believe that the interest rate will remain unchanged, partly because we estimate that core inflation will continue to moderate and labor market data will not justify further tightening. But the balance of risks is tilted upward in light of the continuation of the war.

The employment report for July is expected to be the main event of the week. The consensus stands at an addition of about 85 thousand jobs and stability in the unemployment rate. Any significant surprise (up or down) may significantly affect the pricing of the interest rate in the markets.

Private consumption and investments in artificial intelligence continued to lead growth in the USA: The US GDP grew in the second quarter at an annual rate of 1.5%, lower than expected, but the weak headline figure hides strong growth in private consumption with an increase of 3.2% at an annual rate, supported by the low unemployment rate and higher-than-usual tax refunds received by households. This is alongside continued significant investment in equipment and software. On the other hand, inventories continued to shrink and high imports detracted from growth.

Following the faster-than-expected decline in the Consumer Price Index, the Personal Consumption Expenditures (PCE) price index for June was published this week, which recorded a decline of 0.1%, mainly due to energy prices, but still rose by 3.7% in the last 12 months. The core index also recorded a moderate increase and the annual rate moderated to 3.3%. Although core inflation has decreased and moderated relatively in the last three months, energy prices have returned to rise and we will probably see a renewed increase in July, something that will leave, in our estimation, market expectations for a rate hike in mid-September at a high level.

In the Eurozone, a combination of stable demand, low unemployment, positive growth, and high energy prices increases the probability of a rate hike in September. The earlier-than-expected end of the ceasefire in Iran caused a jump in the price of oil in July, and this is expected to be reflected in inflation data in most of the world. The Eurozone is the first major economy from which an indication of this is received. Thus, in July, inflation rose to 2.9%, slightly below expectations, but it continues to move away from the central bank's target, while core inflation rose to 2.5%.

According to the initial estimate, GDP in the Eurozone grew by 1.8% at an annual rate in the second quarter (after almost zero growth in the first quarter), above expectations and even faster compared to the USA. All four major economies recorded positive growth with about 0.7%–0.9% in Germany, France, and Italy versus 2.8% in Spain. Part of the growth stems from positive private consumption, inbound tourism, net exports (with an emphasis on Germany), and also investments in digital services.

At the same time, the unemployment rate remained stable and low at 6.3%, which illustrates that the rise in energy prices and uncertainty have not yet significantly harmed the labor market. A combination of stable demand, low unemployment, positive growth, and high energy prices strengthens the probability of a rate hike in September.

In the UK, the interest rate remained unchanged, but the number of committee members supporting a rate hike increased. In the UK too, the interest rate remained unchanged at 3.75%, but the decision was more hawkish than expected, by a majority of six against three members who supported raising the interest rate now. Despite the split in the committee, the Governor noted that the majority position was relatively clear, that inflation has moderated and that wage pressures are weakening and financial conditions have also tightened. Therefore, there is no need to raise the interest rate as long as there is no evidence that this is trickling down to wage increases and other products significantly.

Although the Governor signaled that the interest rate will remain unchanged, the risk is still tilted upward, if energy prices remain high and trickle down more into the economy and if the new government presents a more expansionary budget than expected after the summer. It is possible that such a scenario would justify a rate hike, as reflected in the markets, but this is not our central scenario.

The interest rate in Japan remained unchanged, but the need to reduce interest rate gaps increases the chance of another rate hike. The Bank of Japan left the interest rate unchanged at 1.0% after raising it in the previous decision, but presented a slightly more hawkish tone. This is because it estimates that core inflation will rise above 2% towards the beginning of next year, and warned that oil prices, the growing demand for chips, and the weakening of the yen could push inflation further above the target, and therefore there is still room for further hikes.

At the same time, the coordinated intervention of the authorities in Japan and the USA in the foreign exchange market, after the yen weakened again, is an unusual development. While intervention by Japan is not unusual and has been done in recent years, the exception this time is the participation of the USA (even if the full details have not yet been published). The move contributed to a sharp appreciation of the yen, but without reducing interest rate gaps, its effect may fade. Therefore, in our estimation, the central bank will raise the interest rate in one of the two upcoming decisions (in September or October).

In Australia, inflation surprised to the downside, significantly reducing the probability of a rate hike next week: Inflation in Australia was more moderate than expected in the second quarter, but still high at 3.9% and core inflation at 3.6%, both above the central bank's target. The figure was lower than previous estimates and supports the bank leaving the interest rate unchanged next week as well, after raising it three times at the beginning of the year. The figure allows the bank to continue to wait, however, the data does not prove that local inflation has been halted, so a return to rate hikes in Australia is still on the agenda."