PERSPECTIVE | June 04, 2024
After two years of major central banks raising interest rates, the weighted global policy rate stands at a restrictive 7.2%. But with disinflation having taken hold around the world, it is time for central banks to reduce these rates.
Usually, the Federal Reserve would lead the way. But with private domestic demand in the United States expanding at 3% and service inflation proving to be sticky, the Fed is not in a position to cut rates until the summer or early fall.
Instead, The European Central Bank and the Bank of Canada are likely to lead the way in rate cuts.
The International Monetary Fund expects the world economy to grow by 3% this year in part because of those restrictive rates. With disinflation continuing to drive global inflation lower, the path is clear for those central banks to move to more accommodative monetary policies.
We think the second half of the year will feature rate cuts by the major central banks, except for Japan. The cuts will start in June and continue over the next two years.
What is the outlook at central banks around the world? Our global team of economists provides a country-by-country analysis of what to expect for the rest of the year.
European Central Bank
We expect the European Central Bank to reduce its policy rate by 25 basis points at its June 6 meeting, to 4.25%, the first of four cuts that would bring the rate to 3.5% by the end of the year.
Should disinflation continue its current path, it is not out of the question that inflation will return to its 2% target by the end of the year.
Slower wage growth, disinflation and slow economic growth have created the conditions for the ECB to embark on these rate reductions.
The primary risk to our outlook is whether disinflation will continue. We expect the cuts in June, September, October and December. The ECB’s optimal policy rate is around 3%, in our view, and we expect the ECB to pursue that objective irrespective of what the Federal Reserve does this year.
Elevated borrowing costs will continue to be a drag on overall economic activity within the common currency area. The major domestic risks lay within the banking and commercial real estate sectors because of higher borrowing costs.
The major external risk revolves around disruptions to oil and energy flows because of the war in Ukraine and the conflict in the Middle East. These dynamics will weigh heavily in the ECB’s decisions on how aggressively to reduce its restrictive policy stance.
— Joseph Brusuelas
Federal Reserve
The Federal Reserve’s rate cuts are effectively on hold until questions surrounding the increase in service-based inflation can be answered. Our view is that sticky service inflation is a result of turn-of-the-year noise in the data, and that rent inflation will begin its long-anticipated decline this summer.
We see the Fed kicking off its rate reductions in September with a 25-basis-point cut from the current range of 5.25% to 5.5%, followed by another such cut in December. Based on our model, though, we would be comfortable if the Fed began its multiyear rate-cutting cycle in July, ending at a rate of near 3% in 2025-26.
Our preferred model of the Federal Reserve’s reaction function, which informs its rate decisions, includes four elements. First, there is the non-accelerating inflation rate of unemployment. Known as NAIRU, it is the rate that does not cause excessive wage growth and inflation. In our view, it stands at 3.6%. Second, the model is based on the neutral real rate of interest, which we think stands at 1.1%.
Third, the Fed looks to the personal consumption expenditures index as its preferred gauge of inflation. That figure stands at 3.7%. Finally, there is the headline unemployment rate, which stands at 3.9%.
Plugging those values into our model suggests that a federal funds rate of 3.8% would be an appropriate near-term target for the policy rate once the Fed is confident of reaching its price stability requirements.
Although growth, hiring and inflation are likely to cool this year, the U.S. economy will still show enough resilience that the Fed will refrain from reducing rates as aggressively as the European Central Bank, the Bank of Canada and the Bank of England are expected to do.
— Joseph Brusuelas
Bank of Canada
The second half of the year will mark the beginning of a less restrictive monetary policy in Canada.
With inflation declining toward its target, we forecast a gradual rate cut cycle, starting with a 25-basis-point reduction in June. We see a total of four rate cuts this year, of 25 basis points each, which would leave the central bank’s policy rate at 4%.
The cuts will pave the way for greater business investment and consumer spending, easing what has been a subdued growth outlook for Canada’s economy.
We see Canada ending the year at 1% growth, slightly lower than 1.1% last year, before accelerating next year. Gross domestic product should come in at 0.8% for the second quarter, followed by 1.2% in the third quarter and 1.9% in the fourth.
In Canada, growth has been much more modest than in the United States as inflation has slowed. This widening gap has led to a divergence in the central banks’ policies, with the Bank of Canada cutting rates before the Fed, potentially resulting in a decrease in value of the Canadian dollar.
The Bank of Canada’s rate reductions this year will kick off a slow and gradual rate cut cycle, with the terminal rate reaching 3%, significantly higher than the ultralow interest rates of the past two decades.
The reasons for rate cuts are clear. To start, monetary policy has made remarkable progress in restoring price stability in Canada. For three months in a row, headline inflation has fallen below 3%, and all measures of core inflation have also fallen to 3% or below.
Shelter inflation remains the major barrier on the way back to 2%. But since Canada’s housing inflation is a supply issue as well as a monetary issue, the Bank of Canada needs to look beyond housing and consider the consumer price index excluding shelter and the CPI excluding interest rates, both of which are well within the 1% to 3% range.
More disinflationary pressures are in the picture as the labor market cools and businesses keep prices competitive to adapt to consumers’ constraints.
More critically, the Canadian economy has stagnated, even with the help of immigration, which has added hundreds of thousands of workers to the economy. Gross domestic product per capita has fallen, while the unemployment rate has been on the rise.
Keeping rates restrictive for too long would only hamper a recovery and increase the odds of a recession.
To be sure, monetary policy will remain restrictive even after the Bank of Canada cuts its policy rate. The lagged impact of previous rate hikes will continue to resonate. And since the nominal interest rate has stayed constant for nearly a year while inflation decreases, the real interest rate has increased measurably, causing businesses to put the brakes on spending.
– Tu Nguyen
Bank of England
With elections having been called for July 4, the Bank of England will probably reduce its policy rate by 25 basis points, to 5%, at its meeting in July. After that, we expect the central bank would continue to make reductions on the way to a policy rate of 4.5% at the end of the year.
But the risk is that the Bank of England doesn’t start cutting until August and cuts only twice this year.
The Bank of England has established that interest rates are in restrictive territory and are weighing on economic activity, inflation and employment. What’s more, the central bank has said that even if it makes reductions, interest rates would still be in restrictive territory.
This view is in line with our latest Taylor Rule estimate that a policy stance of closer to 4.5% would be appropriate for the UK economy. Under this approach, the Bank of England could cut interest rates three times this year before interest rates move out of restrictive territory.
At the last meeting, in May, two of the Monetary Policy Committee members voted to cut rates, and the forward guidance stated that the risks of persistent inflation were receding.
The other seven members stated they needed to see more evidence of disinflation before they were confident enough to vote for rate cuts.
We don’t think they will have to wait long. As long as disinflation continues over the next few months, as our forecasts suggest, a majority of the committee will have seen enough evidence of slowing inflation to vote for rate cuts in July, regardless of what the Fed does.
This is all predicated on energy prices remaining stable amid the conflicts in the Middle East and Ukraine. The big domestic risk is that a tight labor market keeps wage growth elevated, which would push the first rate cut back to August.
But with inflation likely to reach the 2% target shortly and the economy still barely growing, an interest rate cut before the end of the summer seems highly likely and desirable.
– Thomas Pugh
Bank of Japan
The Bank of Japan, following its long experiment with zero interest rates, will almost certainly be the only major central bank to lift its policy rate this year. We anticipate the Bank of Japan will lift its 0.15% target rate to 0.25% in July and then to a range of 0.4% to 0.5% in October. All the while, bank officials will need to signal their confidence that they will achieve their 2% inflation target.
This will be critical in avoiding further potentially destructive speculation against the yen.
Given Japan’s unique debt dynamics, the central bank will move in an ultracautious fashion as it lifts its policy rate. Recently, the speculative community tested the Bank of Japan’s and Ministry of Finance’s tolerance of a weaker yen. Traders pushed the yen to 160 against the dollar, which resulted in the Ministry of Finance putting more than $50 billion on the table to put a floor under the yen.
These tests are likely to continue, given the large interest rate differentials, growth differentials and the structural budget deficit in the United States.
— Joseph Brusuelas
People’s Bank of China
The People’s Bank of China appears to be waiting for greater clarity on the Federal Reserve’s plans before lowering its medium-term lending facility rate below the current 2.5%. In addition, Beijing retains a reserve requirement ratio of 10% for its banks and a daily fixing of 7.2182 on the yuan against the dollar.
For now, the PBOC is focused on currency stability, with a bias toward depreciation, as the central banks grapple with a most challenging policy environment.
It appears that the PBOC is going to wait until the Fed moves to cut rates, but we believe there will be a window to reduce the policy rate by 10 basis points when the European Central Bank reduces its policy rate on June 6.
An era of debt and deleveraging has arrived in China, ending the economic model that has driven Chinese modernization over the past three decades. The triad of housing, commercial real estate and manufacturing has effectively ended because of a debt overhang in the Chinese household and commercial real estate communities. As such, China is redirecting risk capital toward the manufacturing sector, which is resulting in an overproduction of goods that China intends to export to its major trade partners.
While China’s export volume continues to edge higher, nominal export values have been stagnant as domestic producers slash their prices to keep production going.
Unlike previously, the European Union, India, Japan, South Korea, the United States and the UK are not willing to accept a decline in their share of global manufacturing. This resistance will most likely lead to greater global economic and geopolitical tensions.
Because of the internal economic challenges in China, the PBOC will almost have to let go of the emphasis on currency stability and reduce its policy rate by 20 to 40 basis points to accommodate the widespread weakness in the economy.
The debt and deleveraging era that China has embarked on will take another five to seven years to run its course. Beijing’s focus on boosting manufacturing output is understandable, but it will prove problematic.
Low inflation and a weak yuan would likely attract back some of the production chain players that left during COVID-19—but due to geopolitical tensions and trade fragmentation, not all are likely to return. Chinese officials would be better off boosting domestic household consumption while the PBOC reduces its medium-term lending facility rate to zero to further accommodate domestic investment, especially when the risk of deflation persists.
— Joseph Brusuelas and Tuan Nguyen
Reserve Bank of India
Robust growth but uncertainty in the global market, particularly on the geopolitical front, means the Reserve Bank of India is likely to hold its policy rate steady until later this year.
Unlike the European Central Bank, the Bank of England and the Bank of Canada, the RBI is also waiting until it has a better idea of what the Federal Reserve intends to do.
We anticipate that the RBI will reduce its policy rate—the repo rate is 6.5%—in October by 25 basis points on the way to a terminal rate of 5.5% by the end of next year. The RBI is almost certainly on hold until midsummer and is focused on filling up its foreign currency reserves given the relative strength of the U.S. dollar.
While the current inflation dynamics are healthy, likely spillover from a restrictive policy for an extended period might result in a modest slowdown in the economy. Inflation has moderated to under 5%, heading steadily toward the RBI’s goal of 4%.
The upside domestic risk to prices comes from adverse weather conditions affecting food prices, while the major external risk for India is the price of global oil linked to the purchase of Russian exported crude and events in the Middle East.
Given Prime Minister Narendra Modi’s focus on growth, it is highly likely that the mandate will also influence monetary policy in what is becoming one of the most important economies in the world.
— Joseph Brusuelas and Devika Shivadekar
Reserve Bank of Australia
The Reserve Bank of Australia is expected to maintain its stance at 4.35% well into the latter part of the year. But eventually, we project a pivotal shift by the RBA, with the potential for the first and only rate cut coming in November. Such a cut would bring interest rates to 4.1% by year end.
Demand-driven inflationary pressures, a tight labor market and a stimulatory federal budget pose a risk: that of another rate hike before the anticipated cut.
The RBA’s stance of “not ruling anything in or out” has prompted us to adjust our outlook from when, to if, and now, if at all, regarding the easing of monetary policy.
Policymakers’ concerns regarding persistent inflation are justified, as inflation continues to remain above the RBA’s target range of 2% to 3%.
Though inflation has been halved since its peak in December 2022, significant rebates in Australia are tempering actual prices, particularly in important nondiscretionary components of the consumer price index.
Through the rest of the year, seasonal fluctuations in the labor market will fade, with the unemployment rate creeping up. This is particularly significant because a strong labor market would typically bolster wage growth and consumer demand, aligning with the RBA’s concerns over sustained, demand-driven price pressures.
Looking ahead, we anticipate the RBA will seek a balanced approach to its dual mandate of maintaining price stability and labor market strength. Despite advancements in some areas, challenges persist, led primarily by population growth arising from record migration levels and contributing to inflationary stickiness, notably in the housing market.
Recognizing that certain structural challenges exceed the scope of monetary policy intervention, the RBA aims for a long-term perspective in decision making. For this reason, we think the central bank will wait for two more quarterly inflation reports before reconsidering its policy course.
At the same time, the government’s primary emphasis remains on addressing cost-of-living pressures, as was evident in the budget delivered in May.
To say the budget is not inflationary would be to deny the obvious. The RBA’s job of bringing inflation down to target has now become more difficult. The fiscal measures outlined in the budget, while targeted toward bringing down headline costs, risk stoking demand-driven inflation if Australian households do not show restraint in spending.
With Australia still emerging from pandemic-aligned economic cycles and an election coming up next year, the interplay between monetary and fiscal policy is significant.
While the government aims to achieve sustainable growth along with inflation control, the RBA remains focused on its mandate to manage prices, requiring a restrictive policy.
Taylor Rule estimates indicate the need for further tightening, but the rapid transmission of policy adjustments to the average Australian household through the mortgage channel limits the ability of the RBA to go much higher.
We remain comfortable in our call that the RBA will deliver its first rate cut in November—but just like the central bank, we remain data dependent in our outlook.
— Devika Shivadekar
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This article was written by Joe Brusuelas, Tuan Nguyen , Tu Nguyen and originally appeared on 2024-06-04. Reprinted with permission from RSM US LLP.
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