When we talk about the outlook for interest rates, my rule of thumb is simple: central banks are likely to be slower to start cutting than markets initially expect, but end up cutting deeper. This sounds like a very broad generalisation, but if you look at month-by-month charts of interest rates over the last few cycles (say 30 years) versus market expectations for where rates would go in future (taken at the same historical point – so a snapshot of what investors thought at the time), a loose pattern looks pretty clear to me.
When rates are approaching a peak, markets tend to keep assuming that they will go a bit higher than they eventually do. After the central bank pauses, they tend to assume cuts are coming soon. Once cuts begin, they assume rates will bottom out higher than expected, then start rising again sooner (although in the last tightening cycle, markets expected a slower pace of hikes in 2022 than they eventually got) – but with a lower peak – until they finally catch up with reality just as the peak approaches.
What can we expect from central banks?
Central banks are now in a cutting frame of mind. The Fed cut interest rates by half a percentage point last month and looks certain to cut again in November. At 2.4% in September, US inflation has fallen a long way and poses no barrier to this, regardless of the month-to-month noise. In the UK, September inflation was at 1.7%, below the 2% target, and most of the Bank of England rate setters seem even keener to get rates down than the Fed. Likewise, the European Central Bank.
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Significant rate cuts are now priced in over the next year or so and will probably once again go further than expected. What happens after that is unpredictable. If inflation stays low, so will rates. If it threatens to roar back, memories of 2022 will have central banks tightening more quickly. Last decade, we had no price inflation despite very low interest rates. We can’t ignore the same possibility this time. Rates could head to 2% or lower for the long-term. However, fiscal policy was very tight back then. Now it is becoming looser, especially in the US.
Cheap Chinese exports have helped hold down global inflation for two decades. This continues for now, but is making trade tensions worse and is likely to lead to inflationary tariffs. The world looks more unstable and more prone to shocks. So, structurally higher (but volatile) inflation and rates seem likely. What happens after central banks ease this time will be the first test of that.
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