Justification for rate cuts by central banks

>> Outlook for central banks’ monetary policy

They clearly want to avoid the mistake they made when inflation started to soar – of acting too late. For just as acting too late to hike rates can create problems, so can delaying too long when it is time to cut.

One argument that some central banks are using is that policy is restrictive and, that even if rates are cut soon, policy will still be restrictive. This may hint that central banks are not looking at a quick string of rate cuts but instead, modest and spaced out reductions that ensure just the right degree of policy restrictiveness. It is a tough balancing act for the central banks especially when you consider that the last couple of easing cycles have seen banks slash rates and conduct quantitative easing because they have had to respond with haste to adverse shocks such as Covid and the global financial crisis.

In crisis situations, loosening monetary policy is easy; it is harder when economic growth is still ongoing, labour markets are tight, and financial markets are not imploding. Are central banks right to consider rate cuts at this stage? We think they are. One reason for this comes from the fact that much of the pressure for higher inflation is coming from costs, not demand, and much of this cost pressure is in services, thanks to the high labour market content.

In the UK, for instance, yesterday’s data on average earnings showed that wages are growing at a 6% annual rate. Now that’s above the rate that is consistent with inflation at the 2% target, and yet BoE members seem to be signalling that rates can come down in the next few months. While there is undeniable scepticism within the Bank about some of the official labour market data, other sources suggest that pay awards are still elevated, even if the 6% figure seems like an exaggeration.

What can the Bank do about this? It can maintain the current level of base rates or even lift them to try to force the unemployment rate up significantly and so bring pressure to bear on wage awards. But is this the most efficient way at this juncture? Economic theory might suggest that it is but there may be two reasons.

>> Various viewpoints on central banks' rate cuts

The first is that the labour market is very tight, even in the face of weak growth which suggests to us that it would take a very elongated period of time with base rates at current levels to force the sort of rise in the unemployment rate that might be consistent with lower wage awards. Workers know that the labour market is tight; hence, even a modest rise in the unemployment rate or fall in vacancies will probably make little difference.

What could make a bigger difference to wage negotiations is a sense amongst workers that their cost of living pressures are easing. Now much of this comes from falling inflation, as we know. But a large part comes from the lowering of mortgage costs – and probably rents – as base rates are cut and mortgage rates fall. Right now, housing-related costs are onerous, and it is these that resonate the most when workers bargain for wages.

A recent paper from Bolhuis et al explains the obvious point – in our view – that consumers see the cost of money as part of the cost of living. Of course, the flipside is that lowering policy rates reduces rates that savers earn and that might lead to higher spending but, right now, our sense is that the best thing the BoE can do to bear down on wage growth is to ease cost of living pressures via lower base rates. This might seem as if we are saying that the best way to defeat inflation is to ease monetary policy; the opposite of usual convention. But we think that much depends on what is causing the inflation. If it is excessive demand lifting goods prices then, sure, higher rates are the way to go. But that’s not what is happening right now, as wage and service inflation are the driving forces.