Inflation in the major economies has been coming down with recession mostly avoided. But in a busy election year and against the backdrop of simmering global conflicts, central banks now have the difficult task of taking the politics out of rate cuts.
This time last year there were serious concerns about the effects high interest rates could have on consumers and businesses. As it turns out, investors needn’t haven’t worried so much. Inflation has been falling, major economies have generally held up better than many expected and the possibility of a soft landing for the US, and maybe even the UK, suggest a degree of control in a world that in many other areas appears in chaos.
Maybe that will be looked back on as the easier bit. As more than 70 countries, representing around 50% of global adults and an outsized chunk of global GDP, go to the polls in 20241Â cuts to interest rates risk taking on a political dimension. In addition to businesses pressuring for cuts, in an election year incumbent governments, including those in the US and UK, will be impatient to show that after a volatile couple of years it will be plain sailing from here on in.
For central banks, there is a presentational difficulty. As a test of their independence, they will want to demonstrate that any easing is linked to inflation returning to target. And they also need to circumvent lasting harm to their economies, in the form of recession.
Taking an economic pulse
The US economy has proved more robust than last year’s pessimistic forecasts. Having started 2023 at 6.5%, US consumer price inflation (CPI) ended the year at nearly half that level (3.40%). In fact, core CPI fell almost every single month of 2023. While both measures of inflation remain above the Federal Reserve’s 2% target, (core CPI was at 3.90% in December) the downward trajectory suggests the target is now in sight.
More impressively still, inflation has been brought down with the country’s unemployment levels increasing by only a smidge over the year, from 3.6% to 3.7%. The aggregate number of people in employment actually increased, as the participation rate rose. So instead of tough times stateside, US citizens have, for the most part, remained employed, avoided the direct pass through of the higher interest rates via 30-year fixed term mortgages and also enjoyed decent wage inflation (currently around 5% according to the Atlanta Fed wage growth tracker). These happy events have helped prop up consumer confidence and allowed covid piggy banks to be spent down, keeping recession at bay and equity markets tracking higher.
Turning to Europe and the UK, consumer confidence was not quite so buoyant and this is shown through the anaemic growth profile of both regions. The UK has fared better than Germany. Once the powerhouse of Europe, it is now tagged ‘the sick man of Europe’ appearing as it does to be in the middle of a technical recession (two consecutive quarters of negative GDP growth). But even as confidence has been low, inflation has fallen a long way, employment levels have remained high and European equity markets have performed well.
The first to blink
From here, the key questions preoccupying investors are how far, how fast and who first, will cut rates. Using history as our guide and understanding where each economy is, it would be a surprise if the Federal Reserve were not the first to blink and cut rates. The ECB is most likely to follow and then later the Bank of England.
The UK’s inflation rate is falling but it remains noticeably above the other two regions and the Banks’s 2% target (headline inflation was 4.0% in December). As such, Andrew Bailey will unlikely be the first to move. It is also worth bearing in mind that at the last Monetary Policy Committee meeting, in January, there was still one vote to raise rates!
Adding uncertainty to the path of rates is the US presidential election on 5th November. Ahead of fireworks that night (we will celebrate Guy Fawkes in the UK) the most acrimonious of campaigns is on the cards. The situation in the middle east continues to escalate rather than cool with the recent introduction of the Houthi’s targeting shipping, which will put further pressure on inflation. The Federal Reserve, even more than normal, will need to try and remain out of the spotlight and appear non-political. This will make achieving the 1.5% of cuts priced in by the market for this year very difficult.
March was when most investors expected the Fed to start cutting rates, but following strong economic data releases this has now shifted to May. If there are no cuts before then, there will only be four other meetings before the election date. One option at the Fed’s disposal is to front load the cuts, however, with inflation still some way above target it would be brave, but still remains a possibility, to start with a 0.5% reduction in March.
A watchful wait
Uncertainty translates into continued volatility. Nevertheless, the medium-term path for government bond yields looks likely to be downward. The forecast for equities should be positive in this scenario but given the valuation levels of US equity markets we are circumspect. If the US does manage to avoid a recession, then we would be expecting decent, rather than exceptional, returns from equities, but still above-normal returns from government debt.
What could upset this outcome? Firstly, recession could eventually come through following the long and variable lags from the interest rate hiking of 2022 and 2023. If it does, 1.5% worth of rate cuts may be an underestimate. Secondly, the simmering conflicts in the Middle East and Russia/Ukraine could catch fire.
Equity markets tend not to like armed conflicts and fixed income markets generally do. However, if there is a knock-on effect for goods prices then stickier inflation could stop its decent towards target, leading central banks to keep rates elevated for longer. An active and vigilant approach is once again merited.
