(Bloomberg Opinion) — With the US economy continuing to dodge recession, the Federal Reserve appears to be in no rush to cut interest rates. But with European economies displaying worrying signs of fatigue from monetary tightening, that’s a luxury the European Central Bank and the Bank of England don’t have. They shouldn’t wait for the Fed to make the first move.
The US is relaxed with immaculate disinflation and rip-roaring fourth-quarter growth. A blowout January payrolls report extended the trend. The S&P 500 Index is testing all-time highs so it’s little wonder the dollar index has strengthened 3% this year. US Treasury yields have risen around 20 basis points across the curve this year, and even if the first rate cut isn’t first-quarter business, it’ll probably happen before summer. Real rates, after adjusting for inflation, are running at between 2% and 3%, which is highly restrictive. This implies 75 basis points of cuts are required just to bring the US official interest rate back to neutral.
There are some worrying signs for the US economy. The travails of New York Community Bancorp shows the aftershocks of the sharp rate-tightening cycle are still being felt in the banking sector. The Fed has an ongoing battle with maintaining adequate liquidity, as it closes out the Bank Term Funding Program that saved the day after last year’s Silicon Valley Bank collapse. A huge amount of Treasury debt needs to be issued this year, which may require scaling back the $95 billion monthly quantitative-tightening program. Fed Chair Jerome Powell is keeping his options open, explaining on CBS’s 60 Minutes that while there’s no need to rule out a March cut, it’s not the US central bank’s base case.
In Germany, Europe’s biggest economy, gross domestic product declined by 0.3% last year, the worst-performing Group of Seven nation. Worse looks set to come as December industrial production contracted for a seventh month in December. Europe’s second-largest economy, France, is in no better condition with its manufacturing sector slumping even further into recession.
Siegfried Russwurm, the head of the main German business lobby BDI, pulled no punches in a Financial Times article this week when labeling his government’s energy policies too dogmatic and ‘absolutely toxic.’ The warning signs are mounting with French tech giant Atos SE faltering in efforts to refinance its large debt pile and German commercial real estate in a dire state. The ECB’s January bank lending survey showed loan demand from firms and households continuing to decrease substantially. Euro-area 2023 narrow money supply contracted at a 8.5% pace. Positive real rates are a big financial constraint.
Yet where’s the sense of urgency from policymakers? There’s begrudging acknowledgement at ECB and BOE press conferences that rates have probably peaked, but little to no curiosity as to what dangers lurk over the economic horizon. ECB President Christine Lagarde has stated rate cuts are likely by the summer. But influential Executive Board Member Isabel Schnabel warned again on Tuesday about inflation reigniting.
The picture in the UK is no prettier, with growth still non-existent. Yet two members of the BOE Monetary Policy Committee actually voted for another rate hike on Feb 1. Chief Economist Huw Pill, in a webcast on Monday, said it’s premature to talk about rate cuts, but said they may be possible as ‘our reward to the economy’ if inflation slows further. The parliamentary Treasury Select Committee on Tuesday called the BOE’s active QT program the most aggressive of any major central bank, calling it a “leap in the dark” that demands more careful analysis.
Governor Andrew Bailey remarked at the BOE press conference last week that about 30% of rate-hiking effects have yet to pass through to the economy, largely as mortgage lenders have preempted potential cuts by offering lower-priced deals. Yet with five-year gilt yields rising by about 20 basis points this year, several major home-loan providers have increased their interest rates. It’s misplaced confidence to believe that the impact of tighter policy is conveniently evaporating.
MPC member Swati Dhingra — the only policymaker of any major central bank to vote for a rate cut this year — warned in an FT article Tuesday of a ‘profound’ hit to the UK economy as downside risks might be underplayed. She highlighted that consumption levels are 5.9% below pre-pandemic levels, with December’s retail sales drop of 3.3% providing ‘pretty convincing’ evidence of weakness.
Former BOE Governor Mervyn King, in a July Bloomberg podcast with Merryn Somerset Webb, said central banks are making a big mistake by relying on a ‘neo-Keynesian’ inflation-targeting framework. They’re trapped in a loop, believing inflation expectations are driven by their own focus on the magical 2% level. But, as King pointed out, “inflation is a fall (or rise) in the value of money. So you would think that the amount of money that central banks print would have something to do with inflation.”
The massive pandemic stimulus, matched with a money-supply surge, led to central bank fears of a wage-price spiral unhinging inflation expectations. This hasn’t transpired as all pay and inflation metrics are falling more quickly on the way down than they did when ascending — as ECB member Mario Centeno has pointed out. Money-supply measures have also reversed substantially, yet are rarely mentioned in monetary-policy reviews.
Central bank group-think portends a grim return to fighting off deflation if financial conditions remain so tight. The military saying that prior planning and preparation prevents poor performance is pertinent here. The Fed can pick the moment to ease that suits itself. But Europe needs to forge its own path — and cut rates before the economic downturn builds unstoppable momentum.
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Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.
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