Outlook for central banks’ monetary policy

>> Various viewpoints on central banks' rate cuts

Many other central banks could feel the same way, especially those in emerging markets. No doubt, Holzman is using the expression to further his more hawkish view that the ECB should go very carefully when it comes to rate cuts. But is he right to suggest that the Fed has an outsized influence on ECB policy?

We don’t think this is correct. On the contrary, we see a risk that the ECB, and perhaps other central banks could give the Fed too much respect and so fall short of the policy easing that’s likely to be required. There are a number of reasons for this view.

The first is that we’ve already seen some central banks, notably the Swiss National Bank jump ahead of the Fed with rate cuts and there’s been no significantly adverse impact on the currency. In fact, if we look at the franc in trade-weighted terms it seems as if the rate cut actually reduced the prior weakness in the franc. The Swedish Riksbank eased yesterday and, while it is early days yet, there’s been no major currency fallout so far. The more central banks that jump ahead of the Fed with rate cuts the more emboldened others, like the ECB, should feel, not just about an initial rate cut, but subsequent cuts as well.

A second point is that the economic situation in the US is notably different to most other countries. Demand seems far more robust thanks to many factors including lenient fiscal policy and hence there’s no sense that central banks planning rate cuts soon, like the ECB, are behaving inappropriately. As a result, many people do not believe that currencies are vulnerable to the perception that central banks are playing fast and loose with inflation.

Undoubtedly, there will be the argument that a lack of anti-inflation credibility is not the real reason why the euro – and other currencies – could be vulnerable against the dollar if they cut rates ‘early’. Instead, the vulnerability is just a function of the widening interest rate gap as the Fed holds rates stable, while others cut. But even here, rate differentials certainly do not explain why currencies move all the time. Things are far more complicated than this.

For instance, if we think back to the Fed’s last tightening cycle between late 2015 and late 2018, the bank took rates up from 0.25% to a peak of 2.5%, mostly without reply from the ECB (in fact the ECB cut rates 5bps to zero a few months after the Fed started to tighten). Other central banks in the developed world also refused to follow the Fed’s rate hikes and hence wide rate differentials opened up everywhere – and yet the dollar did not rally.

In fact, on the DXY measure against other major currencies the dollar was lower at the end of the rate-hiking cycle than it was at the beginning. Now, this does not mean that if the ECB and others cut ahead of the Fed that the euro will prove impervious again. Situations change and the market might be more sensitive now.

>> Markets don't do the central banks' work

In the Standard Bank’s view, the experience of the last cycle suggests it is wrong for central banks like the ECB to somehow hold back policy easing just in case there is an adverse currency response. This view forms the third reason why central banks should not fear the Fed and the fourth reason is that, at the end of the day, the Fed is still likely to cut rates. This is an important point because if there is what we might call ‘true’ divergence, with the Fed hiking and others cutting, then the ECB and others might be correct in fearing currency weakness.

However, it seems that the Fed is very keen to retain the perception that the next move in rates will be a cut, not a hike. As we mentioned recently, Fed Chair Powell could have said at the last FOMC meeting that a prolonged period of overshooting inflation might conceivably prompt a rate hike. But he did not. He just said that it would prompt an even longer pause period for rates at their current level. Unless this changes, or unless growth/inflation dynamics in the likes of the ECB preclude rate cuts, we would expect non-US developed-country central banks to cut rates and not worry too much about the gorilla in the room.