Prospects for central banks’ monetary easing cycle

FED may cut rates in September 2024

Money markets seem to be suggesting that the US rate-cut cycle will see policy rates fall to near 3% levels; to around 3.5% in the UK, and just above 2% for the euro zone. Do these projections seem realistic?

One way to try to answer this question is to reexamine the origins of the surge in inflation that caused central banks to hike rates so aggressively. This is useful because, in doing so, we remember that inflation was created by adverse supply shocks; the first from the pandemic and the second from the war in Ukraine. It was not caused by a surge in demand, as the post-lockdown recovery in demand just made up for the lack of activity during the time when people were kept in their houses.

Demand was supported by fiscal easing, but again, in many cases, government transfers to individuals and businesses only partially made up for the income lost by lockdowns. This is an important point because adverse supply shocks are a much bigger problem for central banks than demand shocks.

For instance, car prices rose sharply through the pandemic because there was a temporary shortage of chips; but that’s not something that can be addressed by central banks. Instead, all they can do is to use policy to contract demand until the supply shock ends. This is clearly what they did by lifting policy rates as high as they did, and the only reason there were not more, or deeper, recessions as a result was down to the fact that labour was also in short supply.

As of now, the supply disturbances on the goods side have seemingly disappeared, while those on the labour side seem to have largely gone as well. So, if supply has seemingly returned to the same sort of position that we saw before the pandemic, but demand is still being held down by tight monetary policy, it stands to reason that rates need to be cut.

If demand does not come back into balance with supply the result could be undershooting inflation, which is something that many G10 countries experienced in the pre-pandemic period. This might hint that policy rates need to return to where they were before the pandemic, or even lower.

However, things are clearly not so simple. On one side, the rise in inflation has lifted inflation expectations slightly, and this may make central banks more cautious in the future when it comes to rate cuts. But, on the other, fiscal support during the pandemic and the energy crisis has left governments with high deficits and debt levels, and, as they try to claw back some of this, it could constrain demand even more.

Additionally, there is the argument that policy rates were set at abnormally low levels in the years between the global financial crisis and the pandemic and it is unlikely that such an anomaly will persist in the future. Bearing these other factors in mind, we can see that it is not just a question of central banks cutting rates to return demand to the levels seen before adverse supply shocks lifted inflation. If this was a case of a simple demand shock, central banks might find things a little easier. But supply shocks are tricky to navigate and that could mean that policy rates ultimately land in a very different place from where the market is assuming right now.

This being said, Steve Barrow, Head of Standard Bank G10 Strategy doubts that the market is going to shift these expectations for the landing point materially. He suspects that as more central banks start to ease and as some banks opt for larger 50-bps cuts, the natural inclination of the market will be to take these landing points down a bit to perhaps sub-3% levels in the US, sub-2% in the euro zone and nearer 3% in the UK.

“Central banks might not take rates down to such levels. We don’t know what might happen between now and the end of the easing cycle that could alter the necessary level of policy accommodation. But, as we said earlier, we do think that as the easing cycles gather pace the natural inclination of the market will be to reduce these end-points for the easing cycles,” said Steve Barrow.