Will central banks cut interest rates?

We can see how central banks have taught the markets bad habits over the past three decades. We saw a sharp pullback in stocks that had been on a bull run for most of the year, a sudden rally in a currency that almost everybody had previously been saying was excessively weak, a widening in credit spreads that had always looked illogically narrow, and so on. But there was no evidence of meaningful distress in the functioning of the financial system.

Yet instantly, we had a predictable flurry of whining and pleading for interest-rate cuts on the pretext that the end of the financial world is nigh. Some of the usual suspects even called for the US Federal Reserve to announce an emergency cut (just days after it had kept rates on hold but strongly signalled that cuts are coming anyway) and to slash rates multiple times this year.

Never mind that interventions like those are only potentially justified during a severe systemic crisis. Never mind that long-term investors are better served by high interest rates and market corrections where they can invest at a higher expected rate of return. Never mind that flexible short-term traders are simply focused on the trend, whether up or down.

Today, most seem to believe that there is a right to easy, cheap money; that asset prices should just keep sailing serenely upwards; and that central banks will always be ready to step in to deliver both these outcomes.

What can we expect from central banks?

That belief is rational enough, since policymakers have shown since at least the mid-2000s that they would always prefer to keep policy loose rather than tight, even when that is visibly inflating asset-price bubbles. It is unlikely that central banks will accede to calls for emergency cuts, since there is no sign of severe stress and they dislike making it too apparent that they are being pushed around by market expectations.

However, with the Fed’s change of tone at its latest meeting, the Bank of England’s decision to cut last week even though house-price inflation is picking up, the European Central Bank’s cut in June and the Bank of Japan’s move to play down the chances of another hike soon, the likely direction is obvious. Investors have all sorts of “rules” for whether interest rates are too tight, when central banks will cut and by how much.

My much cruder assumption is instead that central banks are slower to start cutting than markets expect, but that they typically cut further than initially expected. If so, we should expect rates to come down quite a bit over the next year. Locking in some short-term yields on cash may make sense. The harder question is what will happen over the medium term.

The red line on the chart above shows the latest overnight index swap (OIS) forward curve – forecasts for future interest rates derived from the rates at which banks lend to each other for a certain period of time. You can see that rates are then expected to rise again to somewhere around 4% over the long term, but as the other two lines (from late 2021 and just after the Liz Truss budget ) imply, expectations can swing widely and are not a good predictor of the future.

Source: Bank of England

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