Central bankers have pushed back against market expectations for early and deep rate cuts this year, with seemingly limited effect so far, with markets assigning about a 50 per cent probability of a March rate cut by the Fed ahead of last week’s meeting.
Fed Chairman Jerome Powell, in his post meeting comments on January 31, explicitly said that he didn’t believe the Federal Open Market Committee (FOMC) would be ready to cut rates by the March meeting.
While markets did re-price the probability of a rate cut in March down somewhat after the press conference, it wasn’t until the much better than expected January employment data was released on Friday evening that rate expectations for the near term materially declined.
Employers in the US added 353,000 jobs in January against expectations for 185,000 gain and the biggest rise in employment since October 2022. December’s reading was also revised higher, meaning the US economy added 686,000 jobs over the past two months.
The unemployment rate remained at 3.7 per cent for the third consecutive month.
The non-farm payrolls data vindicated Fed officials’ hawkishness, but the market is still much more optimistic about the speed and extent of monetary policy easing this year than the Fed’s own projections suggest: Fed Funds Futures are pricing about 125 basis points in rate cuts over the course of 2024, compared with the 75bp of cuts indicated in the December dot plot, and the market still expects the first rate cut in May 2024.
It is a similar story in the UK, where the market anticipates about four 25bp rate cuts from the Bank of England this year, starting in June. While the odds of a rate cut in May have declined, they remain high at over 40 per cent, even as Governor Andrew Bailey said the Bank needed to “be more confident” that inflation would not only fall to the 2 per cent target, but that it would stay there.
By all accounts, inflation in the major developed economies has slowed sharply at the headline level, helped by lower oil prices in 2023 as well as the impact of higher interest rates on growth and investment, and the consensus expectation is that inflation will continue to decline this year.
Why then are policymakers stressing the need for caution when it comes to easing monetary policy?
For one thing, the fact that markets are already pricing significant easing in benchmark interest rates this year has already had an impact on financial conditions: long-term bond yields have declined since their peaks in November 2023 and equities and other risk assets have rallied; US benchmark equity indices closed at record highs last week.
The easing in financial conditions could spur consumption and investment and boost growth, potentially adding to inflationary pressure even before central banks act to lower policy rates.
In the UK and the eurozone, wage inflation is still much higher than it was before the pandemic, and is too fast to be consistent with a 2 per cent inflation target on a sustained basis.
In the UK, average weekly earnings grew 6.5 per cent year-on-year in the three months to November, while in Europe wage growth is running at around 5 per cent year-on-year, ECB officials said.
Even in the US, average hourly earnings growth accelerated to 4.5 per cent year-on-year in January, the fastest rate since September 2023, although it has slowed from about 6 per cent in Q1 2022.
However, in the US, wage growth has been accompanied by improved productivity which means the inflationary impact is perhaps more limited than in Europe, where productivity growth remains weak.
Policymakers are likely to continue to push back against market expectations for early and deep rate cuts in developed economies this year, over the coming weeks.
While inflation is likely to keep moving towards the 2 per cent target, there is little reason to rush to cut policy rates while gross domestic product growth is still strong, unemployment is low by historical standards and wage growth is running high.
Khatija Haque is chief economist and head of research at Emirates NBD