Economic data have diverged in direction between the US and the 20 nations of the eurozone. In the US, annual inflation rose to 3.5% in March, from 3.2% a month earlier. Unemployment is just 3.8%, retail sales have surged, up 0.9% in February followed by a rise of 0.7% in March. First-quarter estimates for GDP growth have risen from around 2-3%.
At the beginning of 2024 many investors and commentators were projecting successive cuts to interest rates during the year. That has changed. Rates will likely stay higher for longer – but there is a disconnect between Europe and the US
By contrast, growth in Europe has been stagnant for six consecutive quarters, and inflation has fallen to 2.4%. High energy prices have negatively affected German mid-sized manufacturers. GDP growth in Germany, which is Europe’s largest economy, is projected to be just 0.1% this year. Christine Lagarde, President of the European Central Bank, gave a clear indication that the ECB will cut its interest rate in June, from the current 4%, and not follow US policy. ‘We are data-dependent, not Fed-dependent,’ she said.
US policymakers are also data-dependent – hence they are postponing any cuts. Mary Daly, President of the San Francisco Federal Reserve Bank and one of the 19 central bankers who set US monetary policy, said that cuts were not on the short-term agenda: ‘The worst thing to do is act urgently when urgency is not required,’ she said.
At the beginning of 2024 many investors and economists were anticipating four to six interest rate cuts of a quarter-point during the year. The Federal Reserve itself indicated three cuts in its ‘dot plot’ projection in December 2023. By mid-April the expectations were for one or two cuts, possibly none, and possibly even an increase.
Inflation is proving to be ‘sticky’. Many of the underlying causes are supply-related, not cyclical. Sanctions on Russia have contributed to rising commodity prices. An index tracking six industrial metals on the London Metal Exchange rose 8% in the first three and a half months of the year. Oil has risen in price, to over $90 per barrel. The US has a tight monetary policy, but a loose fiscal policy. Jamie Dimon, head of JP Morgan, wrote in his annual letter to shareholders in early April that inflation and interest rates were likely to remain high because of government spending.
Expectations of interest rate cuts in 2024 had been running ahead of what the data was telling us. Much of the anticipation appears to have been based on a desire to return to the policy known as ZIRP (zero interest rate policy), which prevailed for much of the period 2008-2022.
There is a discernible bias towards a perception that a return to low interest rates is ‘good’, and keeping them higher is ‘bad’. In some cases, this bias reflects a vested interest: many in the investment world have a business model that would profit from lower rates, because of their relatively high borrowings. That’s not the same as a lower interest rate being of benefit to the whole economy. If an interest rate cut led to a surge in inflation, this would add to the cost of living for everyone. Also, higher interest rates rewards savers.
Cognitive biases may have been a factor. The ‘feedback loop’ is one: the shared belief comes to be seen as reality. ‘Confirmation bias’ means that we have a tendency to filter out data that is unwelcome, and focus on that which supports our beliefs. ‘Optimism bias’ is common in the business world, and refers to the tendency to make projections based on favourable conditions, and downplay risk.
While ‘higher for longer’ is a common description of the current interest rate regime, in reality the current levels are in the mid-range, not high. Taking a very long view, an analysis by a group of economists, reported by Gillian Tett in the Financial Times, shows that real interest rates, although fluctuating wildly in short and medium-term horizons, have generally been on a falling trajectory over the centuries, as the sheer amount of finance tends to lead to greater efficiency in its use – at least, in aggregate.
So while the phrase ‘higher for longer’ is relevant to the current stance of the Federal Reserve, there are two important qualifications: firstly, ‘higher’ is not very high, by historic standards; and ‘longer’ doesn’t mean forever.
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The author is a Qatari banker, with many years of experience in the banking sector in senior positions.
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