Will many G10 central banks continue to ease their policy?

There are no G10 central bank meetings this week. For many central banks that have eased policy, the key question seems to be the location of the so-called ‘neutral rate’ and whether they need to stop short or go beyond these levels. Of course, all central banks will say that they don’t know where the neutral rate is. Those that have attempted estimates usually suggest that the range of predictions is pretty wide.

The ECB, for instance put a range of 1.75%-2.25% on the neutral rate, while President Lagarde has spoken about a slightly wider range before, of 1.75%-2.50%. The latter suggests that the Bank might be one rate cut away from neutral; or as much as 100-bps away. The Standard Bank’s own sympathies lie to the lower end of this range, which is one reason why we see the base of the rate cut cycle at 1.75% and not the 2% that’s priced into the market and is most often cited by ECB members.

However, while there might be disagreement about the level of the neutral rate, central bank members agreed the policy easing should become more cautious once the bank gets close to the neutral range. In fact, that does not just apply to those central banks that are cutting rates. The Bank of Japan is engaged in a tightening cycle and it too has hinted that it will have to be more cautious as rates move closer to neutral.

The Fed has already paused its policy easing, although many analysts do not believe that this has anything to do with the approach of the neutral rate. FOMC members’ collective view of the neutral rate centers on 3% which is still 150-bps below the current fed funds target. Instead, the Fed’s caution is a clear reflection of the uncertainty surrounding government policy. In addition, the fact that the economy is robust, the unemployment rate is low, and inflation is stubbornly above the 2% target. This also gives the Fed license to hold back from any further rate cuts at this stage.

The Standard Bank believes that the Fed’s caution is fully justified, as there does appear to be evidence that uncertainty around government policy, particularly on tariffs, is leading to concerns of higher inflation. For instance, last week’s University of Michigan consumer expectations survey showed a 5-10-year inflation forecast of 3.5%; higher than anything we have seen for decades, including, of course, 2022 when actual inflation rose to over 9% on the CPI measure. Of course, not all surveys of inflation expectations are as elevated and, if we look at market-based inflation expectations, they remain quite becalmed. But, while there is no need for the Fed to panic at this stage, there are some dangerous signs looming, and, unless this changes, we doubt that the Fed will be able to ease policy until very late in the year.

The rise in inflation expectations also makes us wary of predicting lower bond yields at the moment. Treasuries have managed to recover from the above-consensus CPI data for January, and Friday’s PCE price data might help some more on this score as the consensus is for more modest 0.3% monthly increases for headline and core prices. Nonetheless, while inflation expectations are pointing upwards, we still see a risk that 10-year Treasury yields could test the 5% barrier again.

While most G10 central banks won’t want to see sharply higher inflation expectations, the Bank of Japan has been encouraged that inflation, and expectations for inflation have increased. For defeating the disinflationary mindset has been a challenge that the Bank has long failed. Right now, victory seems to be in sight; after significantly above-inflation wage awards last year, it looks as if this year could see similarly elevated wage deals. The BoJ has been able to keep up with these developments by inching policy rates up; a process that seems likely to continue.

In fact, it might be the case that the BoJ starts to get too much of a good thing, as inflation could rise too far above target, particularly if recent increases in food prices prove a taste of what is to come in the future. At the moment, the Standard Bank is looking at another 25-bps increase in the key policy rate to 0.75% in Q3 with this level persisting through to year end. However, it doesn’t mind admitting that a further hike to 1% could easily occur before the year is over.