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Rate decisions made over the past 48 hours sum up the varied trade-offs facing central banks around the world. The Bank of Japan, US Federal Reserve and Bank of England all met this week — and they each shifted policy in a different direction.
On Thursday the BoE cut interest rates, for the first time since 2020, by 25 basis points. The cost of credit had stood at 5.25 per cent, a 16-year high, since last August. The day before, the Fed held rates but signalled that it may join the BoE and the European Central Bank (which cut rates in June) by making its first cut in September. Earlier on Wednesday, the BoJ raised rates — for only the second time since 2007 — to around 0.25 per cent.
With the exception of Japan, the global rate-cutting cycle is under way. Most major central banks have already made their first cuts, or are on the cusp of doing so. The BoJ is responding to a weak yen, and signs that the country may finally be winning its long battle with deflationary dynamics. But elsewhere, the global inflationary genie — triggered by the pandemic and war in Ukraine — looks to have been largely contained. Composite annual price growth in advanced economies has fallen from 7.9 per cent in October 2022, to around 3 per cent recently.
Higher rates have squeezed demand, and central bankers deserve credit for helping to contain and bring down inflationary pressures. Attention is now turning to what the climb down might look like. Rather than a gentle series of quarter-point drops, it is likely to be characterised by skips and jumps.
Take the Fed. Chair Jay Powell said on Wednesday that the central bank needed further evidence that inflation was falling persistently, before cutting. The risk is that US economic activity becomes overly constricted. The Fed’s preferred measure of inflation fell to 2.5 per cent in June, and price pressures are easing. The jobs market is cooling and wage growth is falling.
But, US unemployment, credit card delinquencies and jobless claims are rising under the pressure of higher rates. And, economic slowdowns have a tendency to spiral. That makes calibrating the easing cycle with economic activity difficult, particularly as rate changes act with a lag. Mis-steps are possible, and gentle cuts may not always be appropriate.
In Europe the calculations are slightly different. The decision to start cutting rates in the UK, with inflation bang on target, made sense. It was also reasonable for BoE governor Andrew Bailey to caution against consecutive cuts, with services inflation at 5.7 per cent. He echoed ECB president Christine Lagarde, who said the Eurozone central bank’s next meeting in September was still “wide open”, even after holding rates in July. Indeed, wage growth is faster on the European side of the Atlantic.
Other factors complicate the journey down too. First, central bankers are still debating how the pandemic, geopolitics and ageing demographics may have influenced the neutral level of interest rates — or the point where policy is neither stimulating nor restrictive — which will determine the pace and length of the cutting cycle. The BoE and Fed are also grappling with sketchy jobs data, due to low survey response rates. Second, rate-setters will need to factor in how differences in central bank policies may feed back to domestic economies via exchange rates. And finally, there are political risks. A second Donald Trump presidency could have implications for the Fed’s independence.
Nevertheless, business and households — which are still facing high price levels — will welcome the turn towards lower rates, after four years of rate rises and holds. Just don’t expect the way down to be any more predictable than the way up.
