Where next for interest rates?

After the relentless rises of the past year and a half, it looks as if rates may finally be close to peaking. At least, that's the way it appears after the latest round of key central bank rate-setting meetings.

While the European Central Bank (ECB) raised its key deposit interest rate to a record 4 percent in September, the tenth rise in 14 months, the move was largely anticipated. And both the Fed and the Bank of England left rates unchanged at 5.25 percent, in the latter case apparently in response to lower-than-anticipated headline inflation.

But don’t hold your breath. Cheap money won’t return any time soon. With inflationary worries still keeping central bankers awake at night - oil, for example, is at new highs - rates are now much more likely to stay higher for longer.

"We are not anticipating a first cut before June 2024," says Simon Weiss, Head, Fixed Income, Commodity & Currency Strategy, at LGT Bank Switzerland. And even then, he cautions, inflationary pressures will be decisive. "Central banks don’t have too many tools to fight inflation. Interest rates are the main one."

So how did we get here? After all, until very recently low interest rates were a fact of life. Three big turning points over the past 15 years or so help explain the shift to higher rates and today’s central bank conundrum.

Three key developments

1. The 2008 global financial crisis, when a housing market bubble fuelled by cheap credit and lax lending burst, saddled the banks with trillions of dollars of worthless subprime mortgages. To mitigate what became known as the great recession, the Fed, whose mandate since the 1970s has included the duty to maintain maximum employment, slashed interest rates to zero. It worked - but at the cost of fuelling inflation. Rates eventually started rising again until 2016, when alarming economic data from China panicked the stock markets and forced a pause in rate hikes. 
2. Quantitative Easing (QE), when central banks buy bonds and other financial assets from leading banks to boost liquidity and thus economic activity, was first used by the Bank of Japan in 2001, after negative interest rates had failed to pull the world’s third largest economy out of recession. QE came into widespread use after the 2008 global financial crisis, and especially after the European sovereign debt crisis of 2009-10. By the end of 2016, the ECB had injected more than EUR 900 billion into financial markets as part of its QE programme.  

3. The Covid-19 crisis, which caused a deep economic downturn in the US - and just about everywhere else. In response, the Fed doubled down on QE. Indeed, thanks to similar asset purchase programmes, the world’s central banks doubled their balance sheets within two years. 

   

   Meanwhile, key interest rates hit historic lows. By 2022, however, as the world started to emerge from the pandemic, inflation was accelerating sharply, exacerbated (especially in Europe) by the war in Ukraine, which has fed energy price inflation, and renewed lockdowns in China.

Treading a fine line

Tasked with maintaining price stability, central banks have responded to these inflationary challenges by raising interest rates to historic highs. Indeed, the past 15 months have seen one of the steepest monetary tightening cycles in four decades, with virtually every major central bank hiking rates or allowing yields to rise.

Yet policymakers know they are treading a fine line. The ECB decision in September was the closest taken by its officials since tightening began. ECB President Christine Lagarde reiterated at the press conference following the rate hike announcement that the ECB had not yet begun to think about rate cuts. Similarly, Fed Chairman Jerome Powell, who has emphasised that the Fed would keep key rates high until inflation was on a sustainable path toward its 2 percent target, indicated that another rate hike can be expected in the current year.

(The Fed now expects inflation to average 3.3 percent in 2023, which is a 0.1 percentage point lower than its June forecast. However, core inflation, excluding energy and food prices, is expected to be 3.7 percent. For 2024, the Fed expects an inflation rate of 2.5 percent, or a core rate of 2.6 percent.)

But inflation is not all that central bankers worry about. They are acutely aware that a prolonged period of high rates not only sends borrowing costs up for both consumers (in terms of mortgages and credit card debt) and companies (in terms of capital costs and debt financing), it also damages economic growth. LGT expects this to remain flat in the US and the eurozone for the rest of this year.

It's worth remembering that the yield curve, which indicates investors' expectations regarding future interest rates, economic growth and inflation, and is a key determinant of bank profitability, has been "inverted" (or negative) in Europe since Q4 2022. And with the US yield curve inverted since July 2022, we should note that yield curve inversion has preceded every US recession for the past half century.

Will a longer cycle mean a softer landing?

Of course, the impact of monetary policy on growth comes with a considerable time lag. Recent growth rates have been low but positive, and the record monetary tightening has not slowed economic activity too much yet. What’s more, the lending market seems to be functioning well. Corporate refinancing is not necessarily much more difficult (for some companies), although it has become much more expensive. 

Still, the European Commission is cutting its outlook for the eurozone to just 0.8 percent expansion this year, largely due to poor performance by the bloc’s biggest economy, Germany. In the meantime, oil prices are rising, and the mood in the US housing market has clouded yet again, mainly due to rising mortgage rates.

All of which leads Simon Weiss to reflect on how complex the task of setting interest rates has become. "Historical analysis of all Fed interest rate cycles since the 1970s shows that the period between the last rate hike of a cycle and the first cut is just under six months," he observes. But "in contrast to previous cycles, the further development of inflation is likely to play a decisive role in defining the end of the current one." For the US, he anticipates a "significantly longer than average" period at peak rates. Meanwhile, the chances of a so-called soft landing, with low inflation and little economic damage, remain unclear.