Global Interest Rates: Pause, Peak or Peril?

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Following the sharpest monetary tightening since the early 1980s, many central banks are pausing their hiking cycles: creating time to assess the impact of their work and reducing the risks of a policy overshoot, while maintaining optionality if inflation proves stubborn. 

The Fed is likely to follow with a pause of its own this week.

Crucially, a pause is not necessarily a peak. With underlying inflation still too high and the risks of a resurgence in inflation still present, central banks are likely to err on the side of doing too much rather than too little.

Rather than concentrating on near-term central bank communications and tactics, the focus should remain on inflation fundamentals — including the structural medium-term drivers that are unlikely to be tamed by real interest rates that are barely positive.

Further interest rate increases are likely over the next few months and any reductions of rates are unlikely to begin before well into 2024.

Markets have not yet adjusted to what will be required to tame inflation in the current cycle or the fact that monetary policy will need to run persistently tighter during a period of archipelago-like, fragmented globalisation. The disinflation of the long post-Cold War globalisation of steady integration has been replaced by structural inflation from the ‘de-risking’ of the global value chains, the re-wiring of global energy systems, and the prioritisation of resilience over efficiency in areas from health to defence.   

Volatility, pauses and peaks

Ever since inflation erupted following the COVID re-openings, global interest rate volatility has been elevated.  Markets have continually underestimated both what would be required to tame inflation as well as the resolve of central banks to take the necessary actions.  Consequently, asset prices have oscillated sharply, driven less by fundamentals for growth and earnings than by the interest rates used to discount those cash flows.

This cycle has been repeated in recent weeks as expectations that key interest rates had peaked − particularly for the Fed funds rate − were dashed amid mounting evidence to the contrary.  

Into this volatile mix, central banks are deploying, to varying degrees, a strategy of pausing their hiking cycles: creating time to assess the impact of their work and reducing the risks of a policy overshoot, while maintaining optionality if inflation proves stubborn. The challenge has been that markets and households have all too readily equated pauses with peaks, reinforcing the perils of persistent inflation.

Central banks are entering the danger zone

Central banks have engineered the sharpest monetary policy tightening since the early 1980s with, for example, the Federal Reserve raising its funds rate by 500 basis points in just 14 months. The European Central Bank has raised its deposit rate by 375 basis points in 10 months − the largest and sharpest monetary tightening in its history. 

Central banks know that monetary policy famously works with long and variable lags. The speed of interest rate hikes means there is substantially more tightening in the economy to come, particularly in Canada, Australia and the UK, where large mortgage debt with relatively short, fixed rate horizons will re-price over the course of the next few years. In Canada, average mortgage payments will rise by 25% in the next 18 months and debt service ratios will spike to levels not seen in 20 years. In the UK, Bank of England Governor Andrew Bailey estimates that around two-thirds of tightening’s effects are still to be felt.

Central banks can take some comfort that headline inflation rates have been coming down and are expected to fall further. US headline CPI inflation came in at 4.9% in April, the first time it has been below 5% since April 2021. In the eurozone, headline inflation in France, Spain and Germany all came in far below expectations in April.

In parallel, some structural drivers of inflation have been unwinding. Post-pandemic supply chain disruptions are receding sharply − the New York Fed’s Global Supply Chain Pressure Index fell to a record low in May. Commodity price pressures have also largely fallen back to levels last seen in May 2021, following their peaks in the wake of Russia’s invasion of Ukraine.

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