What will central banks do this year, and how will it impact businesses?

As 2023 began, markets were optimistic. With inflation easing, investors expected the world’s largest central banks to pause their cycles of rapid interest rate hikes, and perhaps even cut rates later in the year.

However, inflation may prove stickier than expected, and economic resilience could prompt policymakers to keep their feet firmly on the brake pedals.

So what might the three key central banks – in the US, the Eurozone and the UK – do this year, and what impacts could monetary policy have on the business climate?

In the coming months

In the near term, it looks like all three central banks may continue to tighten policy, albeit at different paces.

The next Bank of England (BoE) move looks uncertain. The UK economy is struggling but inflation is proving more persistent than in the US and the Eurozone. Amid this difficult policy environment, members of the bank’s Monetary Policy Committee (MPC) are divided. If the officials can’t agree on the best course of action, then it’s even harder for commentators to predict.

It currently looks like a smaller 25bps hike is likely at Threadneedle Street’s March meeting. However, data will be especially important over the next month. A weaker economy and easing inflation could mean the bank holds rates. Better-than-forecast data and persistent inflation could convince the MPC to enact another half-point hike.

Meanwhile, the European Central Bank has committed to another 50bps hike at its March meeting. After that, it’s unclear and the decision will also depend on the data.

Across the Atlantic, the Federal Reserve had already become the first of the three banks to downshift to quarter-point rate rises. However, it also has the highest interest rates overall.

Many had expected this to signal a dovish shift in the Fed’s thinking, but then a scorching-hot employment report saw markets frantically betting on continued rate hikes from the US central bank. While it’s unlikely the Fed will move back to 50bps rises, it may continue with 25bps moves over the coming months.

Second half of the year

Of course the further ahead we look, the murkier the forecast. But while there are many unforeseeable factors that could influence monetary policy moving forward, we can make an educated guess based on current projections.

With the UK’s economy in dire straits, traders are expecting the BoE to end up cutting rates later this year. The bank expects inflation to fall sharply, which would allow it to lower interest rates to get the UK’s sluggish economy moving again.

Meanwhile, hopes that the Federal Reserve would do the same were recently dashed. After the Fed decision, Chair Jerome Powell said ‘given our current outlook, I just don’t see us cutting rates this year.’

Although markets initially didn’t believe Powell, the red-hot US economic data in early February did the trick. It now looks as though the Fed will hold interest rates at a 15-year high throughout 2023.

The ECB is harder to predict. In January, a Bloomberg poll of economists found that most expected the bank to hike by 50bps in February and March, then 25bps in May or June. That would see the deposit rate peak at 3.25% before the ECB began cutting in July.

Officials have pushed back on these bets, saying that they don’t expect to lower borrowing costs this year. However, Eurozone inflation has fallen rapidly and the full effect of the ECB’s aggressive rate hiking cycle has not yet fully fed through into the bloc’s economy. If inflation continues to ease and the Eurozone economy begins to buckle, the ECB could end up cutting rates.

How could this impact businesses?

Economic conditions

We may see monetary conditions tighten through the first half of 2023. Borrowing costs will rise, consumer spending could decline, and the US, UK and Eurozone economies may continue to slow.

All three economies are at risk of recession. However, the UK seems the most likely to experience a downturn and the US the least, with the Eurozone somewhere in the middle. The ideal scenario would see all three economies avoid a recession, and while that seems unlikely it’s not impossible.

Regardless, the next few months or so could be tough. Businesses may need to build resilience as costs remain elevated and consumers tighten their belts, leaving companies to compete for their custom.

In the second half of the year, and into 2024, those firms that are agile enough to capitalise on an expected economic rebound and fall in borrowing costs could get ahead of their competitors. Key for many businesses this year will be to weather the storm and prepare to seize the opportunities once it passes.

Exchange rate volatility

If the BoE, Fed and ECB act as markets currently expect them to, we could see the pound weaken, the US dollar strengthen, and the euro stay somewhere in the middle. However, this could easily be upended by new inflation data, economic developments, or another unexpected shock.

As there’s still so much uncertainty around what will happen economically and how the central banks will respond, exchange rates could remain exceptionally volatile.

If you’re handling multiple currencies, it’s important you take steps to minimise your exposure to FX fluctuations.

With a tailored risk management strategy, you could make your transactions more cost efficient and your cash flows more predictable, all while insulating your profits from unfavourable exchange rate movements.

If you want to find out more about how we can help you with your currency needs, please do get in touch. We’re happy to talk through our services and give you free expert guidance, and there’s no obligation for you to trade.

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