THINK Ahead: Central banks' unwritten rule
Life is full of unwritten rules, and let’s face it, nobody does this stuff better than us Brits. Eye contact on the London Underground? Absolutely not. Jumping a queue? Tantamount to declaring war. And let’s not forget the need to say “sorry” when somebody else walks into you…
Given Britain semi-invented central banking (ok with a little help from Sweden), it’s no surprise that the world of monetary policy also has its fair share of these silent understandings. The biggest of all? The idea that interest rate cuts happen in gradual quarter-point increments.
But it’s a rule that is no longer fit for this day and age. In an era where mortgages are very rarely on floating rates – and corporate hedging is more commonplace – cutting rates in bite-sized chunks won’t always do very much. Not very quickly, anyway.
Just look at the 2022 interest rate hiking cycle. It was the most aggressive we’ve seen for decades, yet the average rate on outstanding US mortgage debt increased by a mere 0.7pp from its pandemic low. That’s despite rates on new 30-year lending soaring from 3% to a peak of almost 8%.
Monetary policy has become more like controlling an oil tanker. And it means central banks run a much greater risk of ending up behind the curve. If officials decide rates need to go to neutral, or even accommodative territory, you can make a decent case for getting there ASAP.
None of this is new. But it's key to understanding how central banks are likely to react through the second half of the year.
Take the Bank of England. The hawks – specifically Chief Economist Huw Pill – aren’t at all convinced that rates should be cut at all. This week’s inflation data will only reinforce that view. The doves, by contrast, have been gunning for aggressive 50bp rate cuts. The result – the very gradual 25bp pace of rate cuts that have come through since last summer – looks like an awkward compromise.
For now, fears about the BoE slipping behind the curve have been allayed by big upward revisions to May’s ominous drop in payroll numbers. But with employment having fallen in seven out of the past eight months, the Bank can’t take anything for granted. An August rate cut is all but guaranteed.
When it comes to the Fed, life is complicated by the very real risk that this summer’s inflation figures come in hot. It wants to be quite sure that a one-off tariff increase doesn’t morph into a more permanent bout of inflation. And that’s still probably true, despite another remarkably benign core CPI figure this week.
But as I argued last week, there are good reasons to think those fears won’t come to pass. And when the Fed is quite sure that the eye of the storm has passed, it could end up cutting rates fairly swiftly. James Knightley, ING's Chief International Economist in New York, thinks that the first cut won’t come until December, but when it does, it could be a bold 50bp move. And if that sounds strange, remember that it’s exactly what the Fed did last September.
The ECB – as the US president keeps reminding us – is much closer to the end of its easing cycle than the beginning. Unlike the Fed or BoE, ECB rates are already at neutral, neither stimulatory nor restrictive for economic activity.
But that doesn’t mean everything I said earlier doesn’t still have some resonance. The ECB’s easing cycle doesn’t look quite as finished as it did back in June, as Global Head of Macro Carsten Brzeski writes here in his preview. Officials are toying with another rate cut – so why not get on with it?
Confidence in Europe isn’t exactly jubilant; both consumer and service sector business sentiment have fallen in recent months. The PMIs, which are updated next week, are unlikely to be particularly buoyant.
In reality, though, absolutely nobody is expecting a rate cut next week. Despite making plenty of noise about the euro – and specifically the risk of breaching 1.20 on EUR/USD – the ECB can afford itself some time to wait and see. Particularly given there’s a pretty decent chance that Trump’s 30% tariff threat on 1 August doesn’t come to pass.
Remember too that things are about to get much more interesting. How quickly will Germany’s fiscal spending splurge show up in the real economy and inflation? Will the ECB be pushed into much faster rate cuts than markets are currently pricing?
