Macroscope | With central banks flying blind, can markets really count on lower interest rates?

Expectations that leading Western central banks will cut interest rates next year have reached fever pitch, but these hopes are likely to be in vain

Investors banking on rate cuts must keep an eye on core inflation, central banks choosing pauses versus cuts and further shocks to the global economy

Reading Time:3 minutes

A trader works on the floor of the New York Stock Exchange on October 27. Predictions of looser policy earlier this year quickly gave way to a dramatic repricing when it became clear to investors the Federal Reserve was not yet done tightening policy. Photo: Reuters

Published: 4:30pm, 23 Nov 2023Updated: 5:47pm, 23 Nov 2023

For some time now, the world’s leading central banks have had a credibility problem. Having insisted that the surge in inflation stemming from the Covid-19 pandemic was temporary, policymakers fell behind the curve and were forced to raise interest rates more sharply and at a faster pace than would otherwise have been the case had they acted sooner.

Even after the most intense monetary tightening cycle in decades, the average core inflation rate – which strips out volatile food and energy prices – in advanced economies stands at 4.3 per cent, according to JPMorgan data. This is only slightly more than 1 per cent below its level at the end of last year, when fears about stagflation were rife. It is also more than double the 2 per cent target of many central banks.

Perhaps more worryingly, central banks’ “forward guidance” – communication about the future course of monetary policy – has been severely compromised. This is partly because of the uncertainty over the outlook for inflation and interest rates, but mainly because central banks have lost control of the narrative.

While policymakers say their decisions are data-dependent, the reality is that they have little confidence in their own forecasts. Not only did central banks grossly underestimate the staying power of inflation, they also did not anticipate that labour markets would prove so resilient in the face of dramatic rises in borrowing costs – a key factor keeping prices elevated.

Nowhere is this more evident than in the United States, whose economy has defied gravity. The excess savings households built up during the pandemic have powered consumer spending, keeping growth relatively buoyant.

People walk past a restaurant with a hiring sign outside in Washington on October 5. Hiring in the US private sector rebounded in October, with education and healthcare creating the most jobs. Policymakers are eyeing the pace of job growth as they work to rein in inflation by lifting interest rates to cool demand. Photo: AFP

For financial markets, central banks’ unclear and unreliable guidance about the policy outlook, coupled with a raging debate over how long rates are likely to remain high, have proved a nerve-racking experience and caused extreme volatility in asset prices. The uncertainty, moreover, has made investors highly sensitive to even the slightest indication of a policy shift.

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.css-1m2rp1p{color:#34b8b5;}Macroscope | With central banks flying blind, can markets really count on lower interest rates?

Macroscope | With central banks flying blind, can markets really count on lower interest rates?