At the end of last year, investors were convinced that interest rates in the world’s leading economies would come down sharply this year. Following the US Federal Reserve’s unexpected signal last December that its monetary tightening campaign was over and that it expected borrowing costs to fall by three-quarters of a percentage point in 2024, bond markets began pricing in much sharper cuts.
What a difference a few months make. At the start of this year, investors were betting the Fed would reduce rates by as much as 1.5 percentage points this year. By the beginning of this week, markets were pricing in roughly half the amount of monetary easing.
As Deutsche Bank pointed out in a report published on Monday, “this continues a theme over the last couple of years, whereby investors have repeatedly been too quick to price in a dovish pivot”. It also raises deeper questions about whether the most aggressive tightening campaign in decades is well and truly over.
The experience of the Antipodes suggests the case for rate cuts is by no means straightforward. At its last policy meeting on February 6, the Reserve Bank of Australia (RBA) not only debated whether to keep increasing rates, it refused to rule out further tightening in the coming months because of persistently elevated inflation which stood at 4.1 per cent in the final quarter of last year. That is significantly above the RBA’s 2-3 per cent target range.
Wage growth in Australia accelerated last quarter, rising 4.2 per cent on an annualised basis, the fastest pace since 2009. The RBA expects core, or underlying, inflation to return to the midpoint of its target band only in 2026, underscoring the stickiness of prices and the need for policy to remain restrictive for a while longer.
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The resilience of Australia’s economy to the sharp rise in borrowing costs is most apparent in the housing market, where prices recovered sharply last year following a brief downturn and have risen for 12 straight months. Home values in Sydney, the most expensive market, in January were only 2.4 per cent below their all-time high in January 2022, according to CoreLogic.
While Australia was highlighted by the International Monetary Fund as one of the most vulnerable property markets because of its high share of variable-rate mortgages, a tight labour market, strong savings buffers accrued during the period of ultra-low rates and high levels of net migration have underpinned demand. This has helped dull the impact of rate increases, making the RBA more reluctant to loosen policy.
Adrian Orr, governor of the Reserve Bank of New Zealand, speaks during a news conference in Wellington on February 28. New Zealand’s central bank kept interest rates unchanged and softened its threat of an increase amid signs inflation pressures are waning. Photo: Bloomberg
In New Zealand, inflation stands at 4.7 per cent – well above the central bank’s target band and higher than in most other advanced economies – partly because of high levels of immigration. Some analysts expected a rate increase, but on Wednesday the Reserve Bank of New Zealand (RBNZ) kept its main rate on hold while making it clear it still considers high inflation a bigger threat than weaker growth. It only expects to begin easing policy next year.
Adrian Orr, the RBNZ’s governor, warned investors not to jump the gun. “As soon as people think you might have done enough, the next guessing game is when are you going to start cutting,” he said.
His comments are spot on and encapsulate the difficulties central banks face in signalling shifts in policy. Just as markets are prone to reading too much into hints from policymakers, central bankers themselves need to be more careful about what they say and how they say it.
As the world’s most influential central bank, the Fed is walking the tightest tightrope. Since chairman Jerome Powell “out-doved” markets last December by revealing that the Fed had discussed when it should begin easing policy, officials have had to push back against expectations of aggressive rate cuts. While the Fed and markets are now more or less on the same page, even the Fed’s prediction that borrowing costs will fall by three quarters of a percentage point this year looks optimistic.
The problem is that the closely watched US labour market is still remarkably strong, and by some measures it is getting tighter. The process of disinflation has stalled, with both headline and core inflation picking up slightly in January on a monthly basis. While many investors believe the US economy is headed for a soft landing, a “no landing” scenario looks increasingly plausible.
People shop at an open air market in Fontainebleau, France, on February 2. European farmers and households are hurting these days because of multiple factors, including persistent inflation, high interest rates and volatile energy prices. Photo: AP
Even in the euro zone, whose economy is much weaker, unemployment stands at a record low while core inflation is proving sticky, mainly because of wage pressures. Bank of America says “such low unemployment across the board, regardless of anything else – strong growth in the US, weak growth in the euro zone – is a puzzle.”
It is more than that. It is a stark reminder that the path for interest rates is not a one-way bet. Australia and New Zealand refuse to rule out additional tightening. While further rate increases in both countries are unlikely, they are not inconceivable given persistent inflationary pressures and the possibility of more geopolitical shocks.
Investors deserve most of the blame for the extreme volatility in interest rate markets. But leading central banks, in particular the Fed, should know better than to prepare markets for lower borrowing costs when inflationary pressures are proving difficult to quell. Leaving rates too high for too long is a big risk, but cutting them prematurely is still a bigger one.
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