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Milton Friedman believed the “long and variable lags” of active monetary policy made its goal of hitting an inflation target essentially unachievable. Central bankers invoked these flaws earlier in this cycle to allay fears of runaway inflation, by claiming that their rate rises would eventually come to tame it. Now that price growth has fallen rapidly, they could end up contradicting themselves by being too slow to cut rates.
The US Federal Reserve and the Bank of England this week followed the European Central Bank’s recent decision to hold rates. With annual price growth now between 2.8 per cent and 4 per cent in the US, the eurozone and the UK, it is clear that the general direction for bank rates will be downwards this year. But central bankers remain in no rush to say when they will start to cut nominal rates. ECB president Christine Lagarde said summer was most likely, Fed chair Jay Powell pushed back on a March cut, and the BoE governor Andrew Bailey wants to wait for more evidence.
Caution is understandable. Central bankers fear that inflation could bounce back. Wage growth is still high by historic standards. In America, economic growth has surprised to the upside. Instability in the Middle East is creating new supply chain disruptions, and the threat of higher oil and gas prices remains.
Central bankers are also trying to manage market expectations. In the US, financial market conditions are only as tight as they were in the summer. As investors started to believe that the rate cycle had peaked, they priced in future cuts. Any suggestion that a cut is imminent could loosen conditions further than central banks want. Markets may have got ahead of themselves. In the US, they have priced in six cuts this year, compared to the three indicated by the Fed’s “dot-plot” of rate projections. Nonetheless, there is a risk that central bankers are being overly cautious.
First, the predominant drivers of inflation in this cycle — supply chain snags, a natural gas price shock and soaring food costs — appear to have washed out. Weaker demand will also blunt the impact of any further supply chain snarl-ups. Goldman Sachs estimates that, as things stand, disruption to shipping in the Red Sea will only raise global core inflation by 0.1 percentage points this year.
Second, although jobs markets remain strong, the evidence of cooling has mounted. Vacancies in Britain are at their lowest since the second quarter of 2021. Wage growth and job openings in the US have also slowed. Three-month annualised core inflation, which focuses on recent trends in underlying inflation, is near 2 per cent across the UK, the eurozone and the US. This means the need to maintain highly restrictive rates has fallen.
Friedman’s lags are also still in play. More fixed-rate lending, particularly in the US and the UK, has slowed the transmission of higher rates to the economy. The full effect of peak rates is yet to be felt. Many households and businesses are yet to refinance; when they do, demand will weaken further. Cutting rates from their current restrictive levels would, then, hardly amount to a significant loosening, particularly as real rates are rising.
The case for faster action is perhaps stronger in the particularly weak eurozone economy, compared to the US. But there are several moving parts, and geopolitical instability makes the task ever more complex. The ghost of Arthur Burns, the Fed chair who cut rates in the 1970s only to reverse course and raise them again when inflation jumped back, is clearly haunting central bankers. Avoiding embarrassment, however, is not a policy objective. If they claim to be “data dependent”, central banks may find themselves needing to cut rates sooner rather than later.