Too early to cut rates?

We have had several forecasts of a potential rate cut for over a year now. Despite everything, several central banks opt for a pause and the probabilities of a decline are often postponed until later. But what about for 2024? Are we close to a rate cut? This is where we will take a more in-depth look at the different central bank guidelines for 2024.

Why do interest rates influence inflation?

Interest rates are used as a tool by central banks to control inflation. They (the central banks) give themselves an inflation target where the economy can find itself in a good balance. When the inflation level is above this target, the central bank will raise rates to slow inflation. This process results in lower spending/purchases as the financing cost is higher. Therefore, when demand falls, it lowers inflation. This is also the case in a reverse situation. Central banks started raising rates in 2022 and the last increases took place during 2023. Here is an example with the FED:

There is a certain delay between the rise in rates and the repercussion or diffusion in the economy, this can take around 12 to 18 months. Consequently, several countries faced an economic slowdown in 2023. That said, even if a good part of these countries are still in an “economic slowdown” mode (low growth without necessarily being in recession) in 2024, the US is exiting of the lot with a more marked resilience of growth and an acceleration since the last quarter of 2023.

What are the effects of a high interest rate?

As explained earlier, a high interest rate results in a higher financing cost. If we take the example of a mortgage loan that was taken out when rates were low, renewing with higher rates can reduce its purchasing power. And since the cost of borrowing is more expensive, there is no incentive to use debt to make new purchases. Consequently, there will be a sorting between expenditures for primary needs versus secondary expenditures. By secondary expenses we mean anything that is discretionary like going to a restaurant or traveling. That said, this does not change spending on basic needs such as food, electricity, heating, etc.

On the other hand, households have more difficulty coping with high inflation because companies have to increase their prices because production costs are higher. As a result, prices rise, and low-income households face rapid price increases.

In another register, this rate increase process will also push households to save their money because the rate levels offered in banks or in monetary funds will be higher. It’s a sort of incentive to save rather than consume. This is also what is happening with banking institutions. They can place excess liquidity with the central bank in order to benefit from the latter’s high rate of return, which allows less liquidity to be left in the financial system. Consequently, the rates that will be offered will be higher. There is also an incentive to move towards money market funds which offer high rates. Here is an example highlighting the progression of money market funds.

inflation, rate, economy
Source : Twitter

The US demonstrates some greater economic resilience

The US is much more resilient than other world powers, which risks making the task more difficult for the US central bank. The chances of a rate cut are very often postponed until later. For the moment, they are projecting a first rate cut this summer unlike last December when the rate cut was planned for March 2024. This type of information changes quite often following new economic data. At the last FOMC meeting (Wednesday), Jerome Powell clarified that it would be appropriate to start cutting rates at some point in the year:

inflation, rate, economy
Source : Twitter

For now, we can see a forecast of 3 rate cuts:

rate, fed, interest rate drop
Source : cmegroup

We could see a slight increase in unemployment in the USA in February but nothing really problematic yet. Moreover, forecasts opt for an unemployment rate which could go towards 4% and a GDP which remains around 2%. However, a greater increase in unemployment must be closely monitored as this could cause a surprise with significant impacts on the financial markets.

inflation, rate, economy, unemployment
Source : Twitter

The goal of having high rates is to slow down growth, but we can see that the US is more resilient and maintains a stable level of growth. On the other hand, you should know that a large proportion of households in the US have fixed-rate debts. Therefore, the increase in rates had limited effects since they kept their rates low.

inflation, rate, economy, debt
Source : appoloacademy

This just limited the new loans such as house purchases for example. That said, wage growth and low unemployment make it possible to continue consuming even at higher prices, even if it is on a credit card.

The case of other world powers

We had a surprise this week with the Swiss central bank starting to lower rates. It’s the first on the west side. On the other hand, it is also very likely that Europe (ECB) or Canada (BOC) plan to lower rates well before the FED if we rely on the fairly pronounced divergence in the graph below.

inflation, rate, economy
Source: Linkedin

The other surprise of the week concerns Japan since it increased its rates for the first time since 2016, putting an end to the negative rate policy. It was based on wage increases by companies and estimates that demand will probably increase subsequently. This is why she anticipated an initial increase.

As far as Canada is concerned, the pressure will be significant if the central bank does not lower its rates because the major mortgage maturities will take place over the next 3 years. Consequently, households will find themselves with a higher monthly payment to pay during renewals, which risks having an impact on other expenses. Economic growth is weaker in Canada with a slight increase in unemployment, which helps slow inflation. However, a high key rate has an inflationary impact on mortgage interests, so there will be pressure in particular over the coming months. Here is an idea of ​​the number of mortgage maturities for the coming months.

Elements that could cause inflation to rebound

We have some elements that could cause inflation to rebound or keep it at a certain level. This is particularly the case with an expansionary fiscal policy. For example, we can see that in the US, new measures have been put in place to make it easier for first home buyers to access this $10,000 credit. This could reduce a mortgage by $400 per month.

inflation, taxes, economy
Source : Twitter

A tax measure in the form of a credit is a stimulus since it involves increasing the fiscal deficit. This could maintain a certain level of inflation in the US. Consequently, it will be necessary to monitor the implementation of the various government budgets. This is the case in Canada with the federal budget for mid-April.

The other important element to take into consideration is a possible rebound in China. Until then, China has exported deflation, which has been beneficial in slowing inflation overall. This is particularly the case in the US. We can see that the importation of deflation helped to avoid a recession.

inflation, deflation, economy
Source : Twitter

That said, we must monitor a rebound in China because it could lead to a rebound in raw materials. Moreover, we can see in the financial markets that large caps are on a double bottom, which could leave room for a rebound.

And finally, a rate cut that is too rapid in an economy that is still very resilient and where underlying inflation still remains high could lead to a further increase. The choice to lower rates will only occur if inflation slows sustainably. This is also why the forecasts are not until the end of summer in order to see the progression.

Too early to cut rates

Overall, it is still relevant that central banks will opt for a rate cut during 2024. Europe or Canada should proceed before the US since they demonstrate more fragility in terms of growth. Therefore, it will probably make sense to lower rates in these areas. Then, everything will depend on the ability of inflation to slow down sustainably and not rebound following a rate cut. This is why if growth is fairly resilient (like in the US), it could cause inflation to rebound in the event of a rate cut. Finding the balance between not cutting rates too early or too late. That is to say, pay attention to elements that could stimulate inflation if we drop too early but also watch out for an increase in unemployment if we drop too late.

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