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Economic and Market Commentary

Major Central Banks Maintain Hard-Line Stance on Inflation

“Restrictive for longer” is now the mantra as monetary policymakers seek to bring inflation reliably to target.
Executive Summary
  • U.S. Federal Reserve policy has helped bring down U.S. price inflation, but before inflation is firmly on the path to the 2% target, we may see higher unemployment than the Fed is projecting.
  • At the European Central Bank (ECB), the bar for additional rate hikes has increased, but inflation trends suggest some risk the ECB needs to hike further.
  • Among the major economies, the U.K. faces perhaps the most stubborn inflation. It held its policy rate steady at its latest meeting, but maintained it will stay sufficiently restrictive for sufficiently long.
  • The Bank of Japan (BOJ) is equally focused on price stability, but with the aim of ending decades of disinflation. If inflation data are supportive, it could end its yield curve control policy as early as this year.

Though inflation is trending downward globally, major central banks haven’t relaxed their restrictive stances. Their price stability mandates and their credibility are at stake.

They may diverge in their approaches, but most developed market central banks have shifted to a new monetary policy mantra: After more than a decade of “lower for longer,” it’s now “restrictive for longer.” Interest rates may remain uncomfortably high until inflation data is comfortably trending toward target (and central banks are acutely dependent on the data).

Investors may be coming to accept this outlook, given market indicators such as interest rate futures and sovereign yields. That said, markets have demonstrated a tendency to romance rate cuts at the first hint of dovish signals from central bankers – but we are cautious about underestimating their resolve. The concept of staying restrictive for as long as necessary appears entrenched.

With their latest policy decisions, the U.S. Federal Reserve, European Central Bank, and Bank of England continued along restrictive paths, though their specific actions and signals varied. The Bank of Japan is equally focused on price stability, but with the aim of ending decades of disinflation.

Fed seeing results from sharp hiking cycle

Fed rate hikes have done a lot of the heavy lifting to bring down U.S. inflation, and the underlying trends in recent data – including the data on PCE (personal consumption expenditures) inflation for August – are good news. The Fed is highly data-dependent now that its policy is well into restrictive territory.

At its September meeting, the Fed delivered a hawkish hold in the policy rate, and projected one more hike in the current cycle along with less easing in 2024 than previously signaled. Facing the balance of risks to its dual mandate, the Fed seems inclined to reduce rates less rapidly than inflation to stay restrictive amid a healthy, even hot, labor market.

The Fed’s latest estimates for U.S. growth, unemployment, and inflation in 2024 suggest a soft landing scenario of unemployment barely above neutral, and growth only modestly below trend. This was a notable shift from prior estimates and from the traditional theory that to drive down inflation reliably to target, some softening in the labor market is required.

The Fed’s soft landing outlook is feasible, but we see clear risks: areas of stubborn inflation along with headwinds facing a heretofore resilient consumer and economy (e.g., student loan payments resuming after a multi-year pause). The Fed may be challenged to enact the additional rate hike it’s currently projecting. (Details in our blog post, “Fed Seems Confident in Soft Landing, But We See Risks.”)

We believe some additional rise in unemployment above the Fed’s projections will likely be needed to get inflation firmly on the path to the 2% target. The Fed would tolerate “two-point-something” in the medium term, but if inflation isn’t moving in a good direction by next summer, it could reengage on rate hikes.

Fiscal policy has been something of a wild card for Fed officials. Amid the broader uncertainties surrounding the debt ceiling debates and a possible federal government shutdown, there’s been a large increase in the U.S. deficit this year alongside accumulated savings from pandemic-era stimulus programs. And the shutdown would likely delay critical U.S. data releases on jobs, inflation, and growth, compounding the challenges for a data-dependent Fed.

European Central Bank faces challenging macro conditions

The ECB delivered what we would call a dovish hike in September, and is potentially able now to pause and see how policy transmits through the economy. The 25-basis-point (bp) rate rise brought the ECB policy rate (deposit facility) to a record-high 4%, and it was accompanied by revised forecasts for slower growth and more stubborn inflation than previously expected. (Learn more in our blog post, “ECB Prioritizes Fighting Inflation Above Avoiding Recession.”)

The ECB, like the Fed, has done some heavy lifting: Significant rate hikes since July 2022 have prompted progress on reducing inflation, but not enough to declare victory. Much depends on the data, which have not been unambiguously encouraging. While the bar for additional rate hikes has increased, inflation trends suggest some risk the ECB needs to hike further, possibly followed by gradual rate cuts but not until late 2024 – less easing than what’s currently priced into markets.

With the policy rate at restrictive levels for an extended period of time, we believe the focus is shifting toward scaling back its accommodative balance sheet policies. The ECB has discontinued reinvestments under the regular asset purchase program (APP), and currently intends to reinvest pandemic emergency purchase program (PEPP) maturities until at least the end of 2024. While flexible PEPP reinvestments remain the first line of defense on the anti-fragmentation front (i.e., the risk of various euro area sovereign yields to respond differently to ECB policy), we believe the ECB is aiming for an earlier cutback in PEPP reinvestments.

For both programs, the APP and the PEPP, we do not anticipate the ECB to categorically rule out selling bond holdings, but envision a gradual and orderly passive reduction of reinvestments. Over the longer run, ECB reinvestment policy will also be influenced by the shape of a new operational framework for steering short-term interest rates, including the size of a structural bond portfolio.

The Bank of England’s balancing act

Among the major economies, the U.K. faces perhaps the most stubborn inflation, especially wage inflation. The Bank of England (BOE) must strike a difficult balance between price stability and the rapid transmission of its policy decisions to the economy. Many U.K. mortgages are five years or shorter, so the sharp rise in BOE rates since December 2021 has households refinancing into much higher rates. Borrowing costs are stifling consumer activity and business investment.

The BOE likely factored this into its September decision to pause at 5.25%, a dovish move in the near term amid a restrictive overall stance. It was a close 5-4 vote, with the minority favoring a 25-bp hike instead of a pause. The central bank reiterated that “monetary policy will need to be sufficiently restrictive for sufficiently long” to bring inflation sustainably to target, and that further tightening would be required if there’s evidence of persistent inflation. Again, the data are critical; we expect core U.K. inflation to fall as monetary and fiscal tightening gains traction.

Bank of Japan focused on inflation from a different perspective

The macro backdrop for Japan differs from other developed economies. After seeing years of disinflation or outright deflation, Japan’s policymakers are comfortable with the above-target inflation seen since early 2022. Indeed, a period of above-target inflation is key to the Bank of Japan’s (BOJ) credibility in stabilizing prices over time.

Under the new leadership of Governor Kazuo Ueda, we’ve already seen several changes at the BOJ, including a material adjustment in July to its yield curve control (YCC) strategy. (Introduced in 2016, YCC refers to the central bank purchasing Japanese government bonds to peg the 10-year yield at 0% and stimulate growth. Read more in our blog post, “BOJ Moves Toward Phasing Out Yield Curve Control.”) If data indicate inflation can sustain more than the BOJ currently forecasts, which we expect, then the BOJ could abolish YCC late this year or early next.

The BOJ left its policy rate unchanged in September. At some point, as the economy reflates, we expect the BOJ will move away from the zero or below-zero short-term rates that have prevailed for over a decade. The policy rate could be hiked to 0% by early 2024.

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