To cut, or not to cut, that is the question…

The central bank easing cycle is being called into question. In the second week of January,?markets were priced for the Federal Reserve (the Fed) to ease policy by 175 basis points this year in seven quarter-point cuts starting in March. Other major central banks were priced for similar outcomes. Following a string of better US growth and inflation prints, market pricing has since shifted to reflect significantly less easing. As it stands today, the market now only expects just over one quarter-point reduction from the Fed for the entire year, with the first full cut not priced until December.

From exuberance to pessimism, the pendulum has swung dramatically in a matter of months. There is now talk of the possibility of no cuts from the Fed, or even extra rate hikes. However, while the tune has changed at the Fed, it is important to remember that not all central banks are singing from the same hymn sheet. Let’s consider each of the major players independently to see how they are likely to react.

Federal Reserve

As late as last September, markets had partially priced another rate hike at the Fed’s December meeting. However, with the three-month core personal consumption expenditure (PCE) run rate at 1.5% — notably below the Fed’s 2% target – Fed chair Jerome Powell was instead able to pause the rate hiking cycle at the December meeting and lay the groundwork for three rate cuts in 2024. Since then, the data has not played out nearly as well. Non-farm payrolls, for example, have surprised consistently to the upside, with monthly jobs growth averaging 276k year to date. Although declines in job openings suggests some recent softening, other indicators, including the quits rate and the National Federation of Independent Business new hiring plans, do not suggest the labour market is suffering enough to require proactive action from the Fed. With growth concerns off the table, inflation has taken precedence. The core consumer price index (CPI), which currently stands at 4.4% on a three-month run rate, has now beaten expectations to the upside every month this year, indicating the final move back towards 2% could be more challenging. While the Fed indicated at its March meeting – via its dot plots – that it still expected to cut rates three times this year, subsequent communications from members of the Federal Open Market Committee (FOMC) indicate there is no rush to get going. Even Powell has now acknowledged that “the recent data have clearly not given us greater confidence and instead indicate that it is likely to take longer than expected to achieve that confidence”, although he has also been clear that the Fed isn’t considering a rate increase either, stating that rates would be left at their current level as long as needed if inflation proved more stubborn. It now feels like the Fed will need to see a run of softer inflation prints to gain confidence that its attempts to bring inflation under control are back on track.

European Central Bank (ECB)

In contrast to the Fed, the ECB appears to be ready to start easing, signalling at its April meeting that sufficient confidence for a rate cut could emerge by the next meeting in June. While FOMC members have been pushing back more recently, it is notable that a few members of the ECB Governing Council had been ready to cut as early as April. Since then, ECB members have publicly stated that, barring some large shocks, they expect to start moving soon. Having peaked at 5.7% last March, core inflation has come in below 3% for the first time since February 2022, and on a seasonally-adjusted basis has been running around 2.5%-2.6% more recently. With an economy that has bounced around zero growth for the last five quarters and inflation that appears to be moving towards target, it makes perfect sense for the ECB to get going with rate cuts. The obvious question remains whether the ECB can pursue a significant easing of policy if the Fed stays on hold for longer. For now, it would appear that the ECB would relish the opportunity to move first and prove that it is not a sheep when it comes to monetary policy. ECB president Christine Lagarde has been very clear that the decision to cut rates would be data dependent, saying that?"it's on that basis that we have to make our decision and not on the basis of any central bank in the world, be it the Fed." The market is currently priced for around three cuts this year starting in June, which seems reasonable.

Bank of England

On first look it would appear that the UK is struggling more than other countries to get inflation down and under control. Core CPI for March came in at 4.2% year on year, while the headline rate stood at 3.2% -- inching down, but not as much as the market had been hoping for, with both rates still significantly above the Bank of England’s 2% target. Nevertheless, at a recent International Monetary Fund event, Bank of England governor Andrew Bailey appeared less concerned. Due to some quirks in the calculations, April should see a 12% decline in energy prices in the UK, which will push headline inflation sharply down towards that magical 2% figure. Bailey was also very clear that he believes inflation in Europe is different to inflation in the US and this could lead to somewhat different paths for interest rates. “The dynamics for inflation are rather different now between Europe…and the US. I think there's more demand-led inflation in the US than we're seeing,” he said. Additionally, the UK could be due a period where inflation hovers around the 2% mark. Even if this occurrence is due solely to base effects, it could still be self-fulfilling in dampening inflation expectations, which in turn may well soften expectations for future wage increases. With the first full rate cut not priced until September, the risk is that the Bank of England may well want to move earlier.

Bank of Canada

The key remark from governor Tiff Macklem after the Bank of Canada’s April meeting was that he was seeing the conditions for a rate cut but needed to see them for longer. Since then, inflation has continued its decline from the start of the year, with the three-month annualised run rate on the Bank of Canada’s preferred core measure, which had been very sticky last year, dropping to 1.3% in March, while the breadth of inflation has also continued to moderate. Forward leading indicators suggest further progress, including more benign corporate pricing behaviour from the Business Outlook Survey. Against a backdrop of labour market rebalancing due to more worker supply via immigration, and with growth showing signs of rebounding, a first cut is on the table barring any major surprises from the next (and final) inflation print ahead of the June Bank of Canada meeting. Although the US and Canadian economies are closely linked, with typically coincident monetary policy cycles, the current contrast in the fundamental backdrop – including a difference in core inflation run rates of around three percentage points – could lead to some central bank divergence.

Reserve Bank of Australia (RBA)

Like the Fed, the RBA is dealing with stickier inflation than it would like. The latest inflation figures surprised both the market and the RBA to the upside, with the trimmed mean reading up 1% quarter on quarter and 4% year on year. As is the case in other countries, Australia’s inflation rate is considerably lower than the year-on-year peak of 6.8% back in 2022, but is still some way above the RBA’s 2%-3% target band, and above the 3.6% forecast by the RBA in its latest Statement of Monetary Policy expectations for the second quarter, which was last revised in February. The latest inflation print vindicates recent RBA statements to maintain maximum optionality, as it has indicated the next move could be either up or down. Also, while the latest inflation reading did beat expectations, it did not do so by as much as the reading back in the third quarter of 2023, which subsequently contributed to the RBA raising rates again in November. With RBA governor Michele Bullock looking to ensure she doesn’t make the same mistake as her predecessor Philip Lowe by committing to forward guidance that quickly gets reversed (back in 2021, Lowe said he expected rates to stay low until 2024) the RBA will likely continue to comment that the next move could be in either direction depending on the data. It therefore makes sense that pricing for the RBA to ease has been pushed back into 2025, although with just 30 basis points of easing priced in overall, this expectation could increase meaningfully if a global easing cycle gets underway.

To thine own self be true

It is safe to say that the data received so far this year has dampened the expectation of rate cuts, with the resulting market adjustment led by the US. However, central bank views are now starting to diverge. The ECB is currently the most explicit about easing policy and appears very likely to start in June. The Bank of Canada may not be far behind, while the Bank of England also appears anxious to get started. The Fed, on the other hand, remains the most challenged given the current data set. However, the extent of the market repricing over the last few quarters exemplifies how quickly sentiment could shift back again if the data allows. It will therefore be critical to monitor incoming data for each major central bank, particularly on the inflation side, to determine their own future path.

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