Central bankers gear up for interest rate cuts

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Milton Friedman believed the “long and variable lags” of active monetary policy made its goal of hitting an inflation target essentially unachievable. Central bankers invoked these flaws earlier in this cycle to allay fears of runaway inflation, by claiming that their rate rises would eventually come to tame it. Now that price growth has fallen rapidly, they could end up contradicting themselves by being too slow to cut rates.

The US Federal Reserve and the Bank of England this week followed the European Central Bank’s recent decision to hold rates. With annual price growth now between 2.8 per cent and 4 per cent in the US, the eurozone and the UK, it is clear that the general direction for bank rates will be downwards this year. But central bankers remain in no rush to say when they will start to cut nominal rates. ECB president Christine Lagarde said summer was most likely, Fed chair Jay Powell pushed back on a March cut, and the BoE governor Andrew Bailey wants to wait for more evidence.

Caution is understandable. Central bankers fear that inflation could bounce back. Wage growth is still high by historic standards. In America, economic growth has surprised to the upside. Instability in the Middle East is creating new supply chain disruptions, and the threat of higher oil and gas prices remains.

Central bankers are also trying to manage market expectations. In the US, financial market conditions are only as tight as they were in the summer. As investors started to believe that the rate cycle had peaked, they priced in future cuts. Any suggestion that a cut is imminent could loosen conditions further than central banks want. Markets may have got ahead of themselves. In the US, they have priced in six cuts this year, compared to the three indicated by the Fed’s “dot-plot” of rate projections. Nonetheless, there is a risk that…