Interest rates should not be cut soon

A year ago, many economists were predicting a recession in the US and the West, which didn’t occur. It appears that they have over-stated the recessionary impact of higher interest rates.
The turn of the new year saw a flurry of headlines in the economics sections of western news media commenting on how the predictions of esteemed economists from a year earlier were wrong. In December 2022-January 2023, the Federal Reserve and other central banks were completing a series of interest rate rises. This policy took interest rates from zero to around 5%, a policy covering most developed economies.
This prompted warnings that bringing inflation down to its target of 2% with steep rises in interest rates from near-zero would likely bring about a recession. Quantitative easing policies were being unwound. Economists noted an inverted yield curve, combined with rising interest rates, indicators which tend to be a precursor to a recession. But other indicators were showing more positive trends, which seem to have been downplayed or overlooked.
The proportion of economists anticipating a recession in one poll, published in the Financial Times in December 2022, was 85%. It was expected that US unemployment would reach 5.5% by the end of 2023. Yet unemployment ended the year at 3.7%, the same rate as 12 months before. Not only did the US avoid recession, but its growth rate reached 3% – relatively high, by historic standards.
This matters for current policy-making, because the avoidance of a recession gives backing to those in central banks who are arguing that interest rates should not be cut soon.
Jay Powell, chairman of the US Federal Reserve, has signalled that interest rates have peaked, but the indications are that a cut is not imminent – policy-makers are looking for clearer signs that inflationary pressures have subsided. In January Christine Lagarde, President of the European Central Bank, indicated that interest rates would not be cut before the summer.
Until recently, many economists were anticipating successive interest rate cuts during 2024, potentially as many as seven, taking rates below the 4% mark. Now, it would appear that there are likely to be around three, probably in the second half of 2024. This was underlined at the Davos summit on January 17 by Gita Gopinath, first deputy managing director of the IMF, who said central banks should move cautiously.
I think that the IMF and the US and European central banks are correct in their judgement. Inflation has been curbed while a recession has been avoided, so the current policy mix is working. If rates were cut soon, inflation could nudge back upwards, undoing the good work and prompting further rate rises, possibly to a higher level.
Inflation can be caused by supply chain shocks, as well as monetary policy and other factors. This was the case in 2022 when grain prices rose sharply as a result of the Ukraine-Russian conflict affecting export routes in the Black Sea. This pressure has abated but attacks this year on shipping in the Red Sea by Houthi rebels is affecting another important trade route that is adding to the costs of sea freight.
Moreover, the fact that recession has been avoided, with unemployment low and growth high in the world’s largest economy, could itself provide inflationary pressures.
Prior to the succession of interest rate rises in 2022-23, we had a decade of near-zero interest rates. During the period of ultra-low interest rates, there was a considerable allocation of capital into esoteric and risky assets, because returns from bonds and savings accounts were so low. Zombie companies were being kept alive. Higher rates have therefore helped to reallocate investments towards companies with a strong business model and prospects.
Moreover the current level of interest rates is not, by historic standards, high. The argument for more aggressive rate cuts has been that a recession would be too high a price to pay to bring inflation down to its target of 2%. Now inflation is approaching that target without a recession. There may have been some luck involved – for example oil prices staying subdued – nonetheless the terms of debate have to shift.
The author is a Qatari banker, with many years of experience in the banking sector in senior positions.