Commentary by Roger Aliaga-Díaz, chief economist, Americas, and head of portfolio construction, and Jumana Saleheen, chief economist, Europe.


  • The Federal Reserve and the European Central Bank each raised their target interest rates by 25 basis points in the first week of May.
  • Markets had priced in rate cuts before the end of 2023, while both institutions signalled rates would stay high to bring inflation down.
  • Vanguard expects peak interest rates to hold until 2024.


For months, US and euro area investors have been sending central banks the message: You’re going to cut interest rates in 2023. The Federal Reserve (Fed) and the European Central Bank (ECB) have responded: Not so fast.

Even as the Fed and the ECB have raised their interest rate targets steadily, investors, concerned about the prospects for recession, have priced in rate cuts by the end of 2023. They’ve done so through both complex derivatives tied to interest rates and the inversion of the yield curve - an abnormal condition in which short-term bonds yield more than their long-term counterparts1.

This week, however, both the Fed and ECB further raised their rate targets by 25 basis points (0.25 percentage points), with both institutions emphasising that inflation remains too high.

The latest Fed and ECB rate hikes - and Vanguard’s outlook

On 3 May, Fed policymakers raised their target for short-term US interest rates for their 10th successive policy meeting in little more than a year. The hike took the rate target to a range of 5% to 5.25% - 500 basis points (bps) above its level before the Fed embarked on one of the more aggressive inflation-fighting campaigns in its 110-year history.

On 4 May, the ECB enacted its seventh rate hike in less than a year. Its deposit facility rate, the annualised rate of interest banks earn on overnight deposits with the central bank, is now 3.25% - 375 bps above its level before the ECB initiated its inflation-fighting campaign in 2022. The bank’s effort to subdue price increases began with rates in negative territory.

In remarks after their respective policy meetings, the heads of the two central banks told investors, in effect: ‘We’re not cutting rates anytime soon.’

Vanguard still expects the Fed to raise rates once or twice more this year and maintain its peak rate target until 2024. We expect the ECB deposit facility to peak at 3.75% to 4% this year and for the central bank to maintain the peak rate until 2024. We also recently increased our expectation for the Bank of England’s (BOE’s) terminal rate, to a range of 4.75% to 5% from our previous expectation of 4.5%. The BOE next meets on 11 May and is expected to raise rates from its current range of 4.25% to 4.5%.

Inflation on the wane - but still too high

To bring inflation closer to their 2% targets, Vanguard believes all three central banks will need to continue tightening monetary policy. Both the Fed and the ECB pointed to still-too-high rates of inflation as the driver behind their interest rate hikes this week.

The chart below shows the latest headline inflation readings of 7% in the euro area and 5% in the US but also the recent downward trend on both sides of the Atlantic.

Central bankers have most recently been concerned with rising prices for services and their greater contribution to headline inflation, which is captured in the bottom panel of the chart. Services inflation is important because it is a good guide to where headline inflation will likely settle in the medium term.

As energy prices ebb, service prices drive headline inflation

Sources: Vanguard calculations, based on data from the U.S. Bureau of Labor Statistics and Eurostat, the European Union’s statistical agency.

Notes: The US chart reflects data for the period from 1 January 2019 to 31 March 2023. The euro area chart reflects data for the period from 1 January 2019 to 28 April 2023. Core goods include all goods except for food and energy. Negative contributions to inflation—most notably by energy prices in 2020 after the onset of the Covid-19 pandemic—reflect outright price declines.

Are we there yet? Competing definitions of “restrictive” monetary policy

Central bankers may be able to end their interest rate-hiking cycles before inflation rates fall to target levels in part because monetary policy changes typically take months to transmit through an economy. In any case, Fed Chair Jerome Powell and ECB President Christine Lagarde have said that once policy rates reach their peak, they will have to stay high—in territory that restricts economic activity—for some time.

So, what is restrictive monetary policy territory?

One definition deems a policy rate restrictive when real interest rates—nominal rates of interest minus rates of inflation—are positive. Real rates remain firmly negative in the euro area. In the US, they have turned marginally positive for some measures of inflation but not others.

A second definition deems a policy rate restrictive when it exceeds the ‘neutral rate of interest’—a theoretical rate that neither stimulates nor inhibits economic growth but supports the status quo. The Fed’s current rate target is roughly double its estimated range of the US neutral rate. Similarly, in the euro area, the ECB deposit rate is roughly double that of some neutral rate estimates.

Taken at face value, the excess of policy rates over neutral rates suggest that rates are already in restrictive territory. However, given that the neutral rate is not directly observable and can only be estimated with a large margin of error, it is hard to be confident we are there.

Higher policy rates and portfolio implications

While measuring the effects of monetary policy will remain challenging, doing too little to quell inflation could impact the living standards of millions of people. That’s why we believe the Fed and ECB will continue to raise rates, even though such aggressive hiking cycles often end in recession.

We continue to expect recession in several developed markets in 2023 and that investors will need to wait until 2024 at the earliest for rate cuts.

In the meantime, our outlook for long-term portfolio returns has increased since the start of rate-hiking cycles as equity valuations have fallen back to more sustainable levels and coupons for newly issued bonds are more attractive.


For example, as of the close of trading on 3 May, 2-year US Treasury notes yielded 53 bps (0.53 percentage point) more than 10-year US Treasury notes. In theory, longer-term bonds should yield more than shorter-term bonds to compensate investors for the extra risk inherent in loaning money to bond issuers for longer periods.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

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