The Federal Reserve (or the Fed) kept interest rates unchanged in June. This certainly was good news for the U.S. markets.

High interest rates lead to high borrowing costs, which increases companies’ and households’ expenses and lowers their incomes.

Some businesses have paused their expansion plans because they couldn’t afford the cost of financing their growth.

This isn’t great news for the economy.

The Fed knows that and keeps interest rates higher on purpose. It wants the economy to cool down. After all, inflation remains a problem for the central banks in most developed nations.

In the U.S., the most recent annual headline inflation reading came in at 4% for the month of May. Not too far from the Fed’s 2% target and much lower than 9.1%, recorded in June 2022. However, core inflation (which excludes food and energy) remains high.

The latest reading came in at 5.3%… not much lower than where it was at its peak in June 2022 (6.6%) and much further away from the Fed’s 2% target.

This core inflation number is the main reason why Fed keeps tightening. Despite skipping an interest rate hike in June, the central bank still considers two more hikes later this year.

Markets are taking notes. The U.S. may end up in a recession, and the Fed’s chair Jerome Powell isn’t ready to loosen the Fed’s policy just yet.

It is closely watching other developed nations and their monetary policies, too.

Central Banks Diverge, But Keep Rates Higher

Canada, for instance, raised its interest rates by 0.25 percentage points in June. This came as a surprise after the country’s central bank paused for two months.

The European Central Bank (or ECB) also delivered a 0.25 percentage-point interest rate increase this month. Christine Lagarde, the President of ECB, made it clear that more hikes are coming for Europe. ECB isn’t ready to stop until it sees inflation under control and close to its 2% target.

The U.K.’s Bank of England was the most aggressive one lately, with a 0.5-pp interest rate hike last month. A recent Reuters poll shows that economists expect another such hike next quarter. They anticipate either a half percentage-point increase in one month or 0.25-pp hikes over two months. It doesn’t change the overall policy much, however. Interest rates are going higher.

Finally, Japan kept its interest rates steady. No surprise, given that the country’s inflation was running at just 3.2% annually in May. The country preferred to keep its policy steady and monitor other indicators, such as wage growth and core consumer inflation.

The Western nations are actively wrestling with inflation using higher interest rates. But central banks may be far from the end of the battle.

“Although policy is restrictive, it may not be restrictive enough and it has not been restrictive for long enough,” said Jerome Powell.

In other words, the Fed is ready to raise interest rates and keep them higher than a lot of investors expect. Canada, Europe, and the U.K. could end up doing the same thing.

We’re not out of the woods just yet. The second half of this year may be volatile. It will be wise for investors to keep their portfolios diversified in the meantime.

Thank you for your loyal readership,

The Financial Star team