The recent meetings of the Federal Reserve and the European Central Bank have left interest rates unchanged, aligning with expectations. However, investors were hoping for clearer signals on when official interest rate reductions would commence, particularly in the United States, possibly as early as March. It appears that such adjustments might take more time than anticipated. While this reaffirms that the era of rate hikes is over, it’s a significant development that has been factored in by markets in recent months.
Investors had been betting on a Federal Reserve rate cut as early as March, but this now seems premature. The Economist recently criticized investor and trader interest rate predictions as “terrible.” While this descriptor might be harsh, it serves as a cautionary note against herd behavior or excessive market enthusiasm. Over the past year, many investors have been quick to assign dates to interest rate cuts, often blending their wishes with predictions. The Federal Reserve’s current projections indicate three rate cuts in 2024. Still, market operators go further, with expectations reaching five or six, starting as early as March.
The latest inflation news is not as encouraging, though not panic-inducing either, and it seems incompatible with an interest rate cut as soon as March by the Federal Reserve. This cut would set the tone for other central banks, including the ECB. The reduction in inflation in the second half of 2023 in the United States and Europe was undoubtedly influenced by restrictive monetary policies and certain tailwinds, such as falling energy prices and lack of supply chain tensions after years of constraints.
However, the new year has brought an end to the decline in energy prices, coupled with emerging difficulties, not yet fully materialized but already causing significant problems, in international transport and supply chains due to the conflict in the Red Sea. Moreover, after the events between the United States and Iran, an escalation of the Middle East conflict cannot be ruled out, amplifying these issues.
As long as geopolitical factors and fuel markets continue to impact inflation expectations and prevent a complete approach to central banks’ inflation targets (2%), it might be premature to bet on more intense interest rate cuts than projected by central banks. In any case, if inflation does not rise significantly, the weakness in economic activity, with some countries hovering around technical recession, confirms that, come what may, a reduction in the official interest rate will occur throughout 2024. It is normal for this rate reduction to come in several doses this year, including at the ECB.
The situation in the eurozone requires more caution. Christine Lagarde’s statements last Thursday after the governing council meeting made it clear: “It is expected that inflation will continue to decline throughout 2024, but the ECB needs to confirm that we are in a more advanced phase of the disinflation process to have sufficient confidence to start reducing rates.” March seems entirely ruled out for the start of cuts in the eurozone.
The ECB initiates changes in its monetary policy more slowly and with much more caution than the Fed. Late spring or summer seems much more likely, especially if European GDP shows more weaknesses in its growth. In any case, regarding price evolution, the upcoming inflation data will be crucial in the ECB’s roadmap. The January flash estimate for the eurozone published today will provide signals—though not definitive—of when we can expect a rate cut in the eurozone. For now, the January inflation data from individual countries published this week suggests, in general—Spain being an exception—that inflation continues to decline, but still far from the 2% target.
Although the ECB remains concerned about wage developments in the eurozone— the famous second-round effects—that would impact the labor-intensive services sector, it hasn’t been a significant concern so far. Inflation in goods should decrease, but it will depend on whether the Red Sea conflict escalates. It already has some effect on goods prices, but so far, it seems manageable. The ECB will also need to monitor the inflation effects of the withdrawal of energy subsidies by European governments.
In summary, it seems necessary to continue exercising caution regarding interest rate cuts, which might be delayed until well into spring or summer, especially in the case of the ECB. The Federal Reserve will likely act sooner, but it also doesn’t seem imminent.