By Colin Attard
A lot is being said about the timing of the first rate cut by the major central banks in developed markets. Until a couple of weeks ago, many economists and central bank watchers were predicting the first loosening of monetary policy in March, after one of the strongest paces of monetary tightening in history. Following the stronger than expected growth and inflation data in the first two months of the year, most notably in the US, expectations for the first rate cut are currently being postponed by three months, from March to June.
Arguably, however, what matters most is not the timing of the first cut but the outlook for the rate cutting cycle. To help answer the question, one should first understand what are the main factors that underpin central bankers’ motivation to pull the trigger. Are rate cuts premised on falling inflation towards or below target, deteriorating economic activity and rising unemployment or simply because policy rates are too high relative to the neutral rate?
One could argue that the first reason justifying a rate cut in this cycle is policy normalisation amid higher real interest rates. Economists attempt to come up with a measure of the neutral real rate of interest, i.e. the short-term inflation-adjusted interest rate that would prevail when output is at potential and inflation is stable. To cool down soaring inflation over the last few years, central banks ratcheted up nominal rates above neutral. Estimates of the neutral rate when adding back inflation expectations range between 2.5% and 3% in the US and between 2% and 2.5% in the Euro Area. With inflation slowing down, admittedly from very high levels, the increase in real interest rates is currently leading central bankers to think about letting off the brake pedal and bring down policy rates lower and closer to neutral. For example, the 10-year US real interest rate estimated by the St Louis Federal Reserve Bank increased sharply from negative territory two years ago to around 2%, which is the highest it has been since before the Global Financial Crisis of 2008. The more volatile 1-year real interest rate, estimated by the same Bank, is even higher at around 3%.
A second reason to cut rates is inflation falling towards or below target. Inflation in the US and the Eurozone came down substantially from the sky-high rates we have seen during 2022 and 2023. The Fed Chair Jerome Powell have repeatedly said that the Fed will pivot when enough evidence of ‘good’ inflation data becomes available, thus putting the markets’ focus squarely on the Fed’s favourite measure of inflation, i.e. the core Personal Consumption Expenditure inflation rate. The rate is currently running at 2.8% on a year-over-year basis, or around half of the peak rate of 5.5% reached in 2022. Chair Powell is on record saying that the Fed will not wait for core PCE inflation to fall to 2% on a year-on-year basis before cutting rates.
A third justification central bankers use to start arguing for rate cuts is slower economic growth and rising unemployment. Given the dual mandate of the Fed, one might argue that this is a more frequently used argument in the US. Whereas this might be the case, worsening aggregate demand dynamics tend to bring down inflation and is therefore relevant also to the inflation targeting ECB. In my view, this third factor might justify monetary policy divergence between the Euro Area and the US. The latest macroeconomic projections continue to point towards a divergence in growth; whereas the ECB had to lower 2024’s Euro Area real GDP growth estimate from 0.8% to 0.6%, the Fed increased its 2024’s estimate of real economic growth for the US economy from 1.4% to 2.1%.
Based on the above, one may attempt to draw certain conclusions. In case of an unforeseen shock, both central banks are sitting on substantial rate cut ammunitions to support their economies, with the ECB’s armour running at circa 150bps to 200bps and the Fed is equipped with circa 225 to 275bps of rate cuts before rates may be considered as being at a neutral level. Secondly, given the inflation scare of the last few years, both central banks will be extra careful not to loosen prematurely as this might again stoke inflationary pressures at a time when they seem to be managing to control inflation expectations. Whereas inflation has indeed retreated significantly from the highs of the last few years, headline HICP in the Euro Area and core PCE in the US are forecasted to fall at around 2% only in 2026.
Bringing all these elements together, it is reasonable to conclude that the rate cutting cycle should be more aggressive in the Eurozone compared to the US. Whereas significant monetary policy divergence between the Euro Area and the US is not typical, if growth dynamics continue to push in opposite directions, some divergences in the policy responses cannot be ruled out. In fact, the market is currently pricing in slightly more easing this year by the ECB compared to the Fed. This will have important implications for the value of the euro versus the US dollar and the relative performance of EUR and USD denominated bonds and equities.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.