A new view of policy rates

Mr. Williams from the NY Fed said this week that rates could be cut in 2024

>> Where will the terminal FED funds rate land?

Policymakers from the US to the euro zone continue to hint that high rates won’t last long. Centeno from the ECB recently said that it’s very important to underline that any rate hikes above neutral levels are supposed to be temporary. Williams from the NY Fed said this week that rates could be cut in 2024 and the futures market, of course, prices in the start of Fed easing before the end of 2023.

It seems to us that all this is based on the supposition that demand in the economy has outstripped supply, and that once high rates have lowered demand, and lowered the risk of persistent inflation, the central banks will be able to cut rates again. You can see why the markets and policymakers make this assumption – because it has worked in the past. But now is not the past. It is different because this inflation is primarily a function of a reduction in supply, not a surge in demand. Perhaps only in the US can the case be made for high demand given Covid-related payouts but, even here, reduced supply is crucial as well.

Central banks can reduce demand (through tighter policy) but they can’t lift supply and if supply does not rise back up, demand might have to be more permanently supressed via persistently high rates. Naysayers will argue that the reduction in supply has been due to temporary adverse supply shocks such as the pandemic and the surge in energy prices resulting from the conflict in Ukraine.

While it is true that these have been big adverse supply shocks that have reduced growth and lifted inflation, it is not true that they are one-offs that are divorced from a more structural supply deficiency that has been in place for some time, and  that they won’t have persistent effects in the future.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said structural supply challenges and hence structurally higher inflation has been in train for some time, well before Covid, and all that the pandemic and the Ukraine conflict have done is to put this supply debasement on steroids. The process of deglobalisation, for one, pre-dates the pandemic, and evidence suggests it may even pre-date former president Trump’s trade war with China.

>> What hinders the FED from raising rates?

The deglobalisation was sowing the seeds of higher inflation and the pandemic/Ukraine simply caused these to germinate far faster than they would have done otherwise. In a similar vein, ageing populations in advanced nations and hence the potential for higher inflation via relatively limit ed labour supply, has been supercharged by the “great resignation” of workers during and after the pandemic. There are other factors as well that suggest the possibility of structural weakness in global supply. One is climate change that both has a direct impact as potentially productive regions, and even countries, see their supply potential curtailed by climate challenges. Another is that investment has to be directed away from producing goods and services to producing the means to tackle climate change.

“We could go on but, suffice to say, our concern is that global supply has been more structurally challenged, and probably reduced, than generally anticipated and this suggests that inflation problems will prove more persistent. Now this does not mean that inflation will rise from here, or will refuse to fall next year and possibly beyond. But the days when central banks habitually undershot their 2% inflation targets are gone. Yes, inflation may dip to sub-2% levels temporarily if central banks produce very deep recessions, but such low levels won’t persist. When we translate this to policy rates and bond yields, we don’t deny that central banks will try to get rates down and the market will pre-empt this by driving longer-term yields down. But the level of rates over the longer-term will still be materially higher than those we’ve seen for a very long period of time”, said Mr. Steve Barrow.