Timing the tricky first rate cut

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Central banking is the archetypal technocratic profession. Interest rate setters must be led by data, and guard against irrational decision-making. That is particularly hard right now. The US Federal Reserve, European Central Bank and Bank of England are widely thought to be at their peak rates, having held policy for months. But with the disinflation process now occurring in fits and starts, there is an understandable queasiness over when to begin easing it.

One overriding fear is that of a “second wave” of inflation. If rates are cut and price growth surges back — as it did in the US in the 1970s — that would undermine central bankers credibility. Many already blame them for being too slow to raise rates in the first place. Some central bank watchers suggest there may also be a “fear of going first” — with monetary policy committees preferring to wait until the Fed begins easing in the world’s largest economy.

Rate-setters need to be as clear-eyed as possible. With core inflation still around 3 to 5 per cent in the US, UK and eurozone, there is still work to do. But with the highly restrictive stance of monetary policy, and growing signs of cooling in labour markets, the risk of over-tightening has been picking up. This means central bankers may need to start cuts sooner than they currently convey, particularly as rate changes take effect with a lag.

After pushing an “almost ready, but not yet” message, the Fed will most likely keep its policy unchanged at its meeting next week. Markets have pencilled in June for the first cut. With annual headline inflation remaining stubbornly above 3 per cent this year — and increasing in February — caution may be justified. But forward-looking inflationary indicators are weakening. Data this week showed a continued fall in small businesses’ hiring intentions — a solid predictor of wage growth and jobless claims. The purchasing managers’ index survey of output prices has also been strongly tracking US inflation, and implies easing pressures ahead.

With core inflation running at 5.1 per cent, the BoE, which meets next week too, is even more cautious. But data this week showed wage growth is slowing. The Office for Budget Responsibility’s latest forecast also shows quarterly inflation falling to the 2 per cent target in the second quarter of 2024 — around one year sooner than it expected in November. Nonetheless, few expect the bank to begin easing before the summer.

The case to begin cutting is perhaps strongest in the eurozone. The ECB downgraded growth in the bloc to only 0.6 per cent this year. Its latest inflation forecast, released at its meeting on March 7, shows inflation back to target by mid-2025. But ECB President Christine Lagarde indicated June would be most likely for its first cut. The ECB will meet only once before then.

A series of data quirks has made reading the runes harder. In the US, economists have raised concerns over how housing costs are measured. They accounted for roughly two-thirds of the annual increase in core inflation last month. The February personal consumption expenditures inflation data — which is the Fed’s preferred measure — is not due until after the Fed meets. The ECB will also likely wait for first quarter wage data, which will only be available in May. In the UK, problems with the official labour force survey mean job market data need to be taken with a pinch of salt too.

Central bankers need to give markets a well-signalled plan of how they will ease policy. They will want to avoid having financial markets digest chunkier 50 basis point or 75bp cuts down the line, which smack of panic. But how smooth the journey back to a more neutral stance turns out to be will in part be determined by how savvy central bankers are in making the dreaded first step.