Big interest rate cuts this year? Ain’t gonna happen

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John Rapley is an author and academic who divides his time among London, Johannesburg and Ottawa. His books include Why Empires Fall (Yale University Press, 2023) and Twilight of the Money Gods (Simon and Schuster, 2017).

Investors were disappointed this week that the Bank of Canada remained cagey as to when rate cuts will finally come. And they may be in store for more of this, as lower interest rates may not come as soon as they want.

The new year began amid widespread optimism in Western countries that inflation had fallen back to earth and interest rates would soon follow. But this was arguably more about faith than facts. Although inflation had receded considerably, it was too soon to declare the fight against it over. There were already signs that the falls were levelling off, at levels above central-bank targets. Worse, core inflation – which strips out the more volatile prices to capture the underlying trend – was falling more slowly than headline inflation.

But perhaps the biggest obstacle to rate cuts was the question of necessity. Although some countries, such as Germany and Britain, had slid into recession, by and large economies were still growing and job markets were still healthy. That raised the obvious question: If things aren’t broke, why fix them? Because the risk of cutting too soon was that inflation would return and central banks would have to reverse course.

Sure enough, the trend of declining inflation appeared recently to reverse direction. Although Canada has continued on a downward path, the latest reports out of Europe and Britain confirmed a persistent stickiness in price inflation. The biggest concern of all to the Bank of Canada will be what is happening south of the border. There, the most recent inflation report found that while headline inflation had continued falling, core inflation had levelled off at more than 3 per cent.

That has led the Federal Reserve governors to cool on talk of rate cuts. Yet even more worrying to them is what lies ahead. The job market remains strong, wage pressures continue rising and surveys reveal that a growing number of U.S. firms are planning to increase prices this coming year, since wages have lately been rising faster than prices, leaving people with more money to spend. Moreover, with global shipping disrupted by Houthi attacks in the Red Sea and low water levels in the Panama Canal, goods prices are also expected to tick upward later in the year.

Meanwhile, liquidity remains as loose as ever and money is flowing freely. Given the high exposure of ordinary Americans to the stock market, continued rises in asset prices leave them feeling better off, which in turn keeps them spending. You just have to look at the soaring price of bitcoin to realize this is not an economy at risk of imminent implosion.

Then there’s activity in the bond markets. The U.S. national debt is rising by US$1-trillion every 100 days, and the result will be a flood of new bond issuance later this year. The financial system may get indigestion trying to absorb all of it. That could put downward pressure on bond prices, which would drive up yields – which is to say, interest rates. But for now, bond markets remain quite liquid, and yields remain low. Those accommodative conditions reduce the pressure on the Fed to ease immediately.

So increasingly, the betting is that interest rates in the United States will stay where they are for the time being. Markets are still pricing in summertime cuts, but the recent data have brought even that prospect into question. Besides, market pricing of future probabilities should be taken for what it is: As the macro-analyst Jim Bianco puts it, Wall Street forecasts what it wants, not necessarily what will happen.

Absent definitive evidence of either further disinflation or an economic slowdown, the Federal Reserve will likely bide its time with rate cuts. And the conventional wisdom is that if it doesn’t cut by the summer, it won’t do so until late in the year at the earliest, for fear of looking like it is trying to influence the outcome of the November election.

Even if Canadian inflation continues to soften, it will be difficult for the Bank of Canada to engage in very aggressive reductions if U.S. interest rates stay where they are. If interest rates in Canada fall much below those in the U.S., the Canadian dollar will weaken, as investors chase higher returns stateside. And if the dollar falls much, the price of U.S. imports will in turn rise, feeding inflation back into the pipeline here, owing to the Canadian economy’s high degree of dependence on U.S. trade.

Things could yet change. There’s some debate as to whether the job-market figures are as good as they seem, or whether renewed imported goods disinflation from China will ultimately outweigh persistent rises in service-sector prices, bringing inflation definitively lower later in the year. But until clear signs of weakening show up in the U.S., interest rates will probably stay about where they are.