When might interest rates fall? This may seem a strange question to ask coming just after the European Central Bank raised rates, and ahead of the Bank of England meeting this week when it is likely to raise rates.
And although the US Federal Reserve is set to keep rates on hold at its meeting this week, it is likely to say that further increases are probable. Even the Bank of Japan, which has kept official rates in negative territory for many years, is talking of an increase, albeit not until year end.
So why am I asking when rates might fall? The reason is that official rates in the UK, US and eurozone are at or close to their peak, and their respective central banks have stated that rate cuts will happen – but only when they feel confident that inflation is moving sustainably to their 2% targets.
So the question is: when will that be? I expect interest rate cuts early next year from the US, with the UK and Europe following shortly after. If I’m correct, this will be a pleasant surprise for the market which is pricing rates to be at or above current levels well into 2024.
So why am I so optimistic? We have all learned that monetary policy operates with long and variable lags. Central banks try to look ahead, tightening policy before inflation takes off and easing before recession hits. The problem is that they collectively failed to anticipate the current surge in inflation. They have lost faith in their forecasting models and are collectively stating that they are “data dependent” without giving details about what this exactly means beyond repeated statements that interest rates could rise further and are likely to stay high for an extended period.
But there is an unusual feature of the economy that is set to change this hawkish stance: unemployment. This is currently close to or below record low levels in all three economies. With inflation above target that makes it easy for central banks to talk tough.
In my view, unemployment is set to rise in all three economies. The US has the best economic fundamentals of the three, but even here employment growth has been steadily slowing. The US three-month average of private employment increases stands at 140,000. That may sound a lot but it is down from 200,000 three months ago and even higher before that. And this is important because labour supply, mainly via revived immigration, is rising by 200,000 a month. Unemployment looks set to edge higher and could probably hit the Sahm Rule threshold, which has accurately identified past recessions, by Christmas. Moreover, although inflation remains above target, the run rate for core CPI inflation over the past three months has fallen to 2.4% – a big decline.
In the UK, employment is actually falling and the upward trend in unemployment seems well established. The problem facing the BoE is that wage inflation is way above the level consistent with its 2% target. The run rate for core inflation is also too high, though that could change with the numbers out this week. The BoE will need to see hard evidence that the weaker labour market is slowing the pace of wage inflation before it can even begin to contemplate rate cuts. But that may come sooner than many think: survey evidence is already pointing to marked slowdown in pay pressures.
Finally, we have the eurozone, where unemployment is at record lows and still falling. Unemployment is a lagging indicator and the data suggests the eurozone is already in recession. Unemployment is likely to increase soon and, although the ECB will also need convincing that this is feeding through to lower wage and price inflation before contemplating a cut, that should be evident by spring.
One encouraging feature is that the recent bout of inflation has not raised longer-term inflation expectations by much. There is a good chance that lower headline inflation will feed rapidly though into lower pay settlements, with the wage:price spiral operating in reverse. This is already evident in the US.
So rate cuts are coming, and when they arrive they should be significant. Much bigger than currently priced in. This should bring relief to all manner of financial markets. The battle against inflation has been tough – much tougher than many expected – but the tide has turned and we should see the fruits of victory before too long.
