Investors, economists, company executives, and regular customers from London to Lyons to Los Angeles have one hope as 2024 approaches: let the interest rate reductions start!

The majority of the industrialised world’s central banks concluded 2023 with a flurry of policy meetings in December that essentially put an end to the aggressive rate hikes that had dominated the financial and economic landscape since 2022. The Bank of Japan (BOJ), the lone exception, never succeeded in ending its negative rates policy and indicated this week at the Group of Seven central banks’ annual conference that a change from that position was not likely.

The positive turn inflation took in 2023 was allowing the other major central banks to pause their rate hikes. The pace of price increases has now decreased to 1.5 times the target, down from an average of 3.7 times the 2% target set by the European Central Bank (ECB), the Bank of England, the Bank of Canada, and the U.S. Federal Reserve at the beginning of the year.

Needless to say, that means doing the “last mile” in the fight against inflation with more effort. The pledge to hold rates high for a longer period of time or raise them again if necessary is being viewed as a hollow threat. Central bankers are reluctant to declare victory too soon and are fighting with overeager financial markets to retain maximum optionality.

Rate cuts, however, do not require inflation to reach 2% in order to start, and 2-handle inflation rates may soon become the standard.

Another type of policy tightening that might not be suitable for much longer is keeping rates unchanged as inflation rates continue to decline.

That’s something that some Fed officials have started to freely cite as justification for the rate cuts they hinted were likely coming next year, particularly if they want to provide a “soft landing” for the American economy.

Although the more conventional conclusion to rate-hike cycles is a sharp slowdown in economic activity, a painful increase in unemployment, and a recession that most of the world has so far avoided, keeping rates restrictive for longer than necessary runs the risk of a more severe outcome.

Higher rates have been hurting rate-sensitive economic sectors including manufacturing and housing for more than a year.

S&P Global’s index of manufacturing activity in developed nations has been declining since October 2022, despite signs that the worst may be over given the latest reading, which is at its highest level since the spring, despite the fact that services activity has typically continued to grow. The output of factories in emerging markets, which had been stagnant for the majority of 2023, increased as well.

There is a big game of chicken going on because market participants are expecting considerably more policy easing than central bankers are probably going to provide it to them.

For example, bond and rate futures markets are currently set up for twice as much decrease in interest rates as the 75 basis point reduction that Fed policymakers themselves predicted last week.

This prompted Chicago Fed President Austan Goolsbee, among other U.S. central bank officials, to admit he was “confused” by the way the market was acting.

On the other hand, people with knowledge of the situation in the United States informed Reuters that it is improbable the European Central Bank (ECB) will be able to lower interest rates prior to June, which is three months later than current market pricing.

Naturally, inflation is the key to everything since policymakers have stated that, in order to ultimately bring price pressures back to their goal levels, they are prepared to endure a certain amount of economic suffering.

With general elections in the US and the UK planned for later in the year, politics could also be a factor.

Close to elections, central bankers who value their political independence could be reluctant to be perceived as seeking to influence the results.

Additionally, a potential new spoiler that would complicate the rate-setting emerged as the year came to an end. Attacks on cargo ships in the Red Sea by Houthi rebels supported by Iran prompted shippers to suspend or reroute freight, creating a kink in the supply chain that could prevent further rapid progress on inflation.

(Adapted from DeccanHerald.com)

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