Central banks’ tough job: A whiff of rate cuts, and everyone breaks out the champagne

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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).

The end of the year has been good for just about every asset class, everywhere. Bonds have shot up in value, bringing long-term interest rates down by more than 1 per cent. Stocks have surged. Bitcoin blew past US$40,000 again and kept rising. Gold and silver are up, and meme stocks, the 2021 fad, enjoyed a resurgence. It seemed like almost everything and everyone was along for the ride, since even the little-loved (lately) German stock market enjoyed a stellar month, the DAX index rising by a whopping 10 per cent in November alone.

It was all driven by growing talk of a coming U.S. Federal Reserve “pivot,” which was confirmed on Wednesday when Chair Jerome Powell said the institution was eyeing three rate cuts next year.

After October’s U.S. inflation report had come in softer than expected, a narrative took hold among investors that the era of rate hikes was over, and cuts would begin in the new year. Anticipating the rebound that would follow, they crowded in to snap up assets they expected to rally – which is to say, just about everything. Accompanying this was a rapid easing of financial conditions, as money began sloshing around freely again. By one measure, access to money had become as easy as it had been about a year ago, when central banks began their rate-hiking cycle.

All of this reveals how difficult a job central banks face: A whiff of hope and everyone breaks out the champagne. For all the supposed money central banks have sucked from the economy, there’s still loads of it about, ready to rush in at the first hint of good news. Central banks know this because they put the money there. Years of loose monetary policy enabled firms and households to accumulate huge volumes of it, and they locked much of it in at long-term, low rates. Because that has left them largely untouched by the rise in short-term rates, they’re still flush and ready to jump back in – especially if they believe that when it comes time for them to refinance, interest rates will again be low.

But risks in the economy still abound. Heavily leveraged sectors, such as commercial real estate, are drowning in red ink. Accordingly, the mantra “stay alive until ‘25″ has taken hold, as owners have been led to believe that if they can just absorb the losses of falling rents and occupancy for another year, a new era of cheap money will come along to save the day.

Yet as a recent U.S. employment report revealed, that’s still a gamble. Echoing similar strength in Canada’s report a few days earlier, the job market may be cooling, but it also remains strong. There are few signs of significantly rising employment, while real wages have continued rising. Not only does that mean demand in the economy will remain good going into the holiday season, but unless labour productivity catches up to wage gains, labour costs will set a floor under prices.

That showed up in the last U.S. inflation report. While headline consumer price inflation continued its gentle declining trend, the core rate remained unchanged, at 3 per cent. Since the start of the year, inflation has more than halved. However, core inflation has fallen by only half that, and most of its decline may now be over.

As I have been predicting for a year, while most of the surge in prices last year was cyclical and was always going to run its course, core inflation was always going to hold steady, causing the overall rate to flatten out at a level higher than the past. That may now have to come to pass.

So the dilemma facing central banks is: Do they force the inflation rate back to their target of 2 per cent with yet more rate rises, or do they learn to live with a slightly higher inflation rate. The latter course of action might dent their credibility. The former would probably require them to induce recessions.

That seems unnecessary. Despite their treatment of the 2-per-cent inflation rate as canonical, there’s little reason to suppose the economy can’t live with a slightly higher inflation rate, especially if it remains stable.

Besides, with the U.S. heading into an election year, the Fed in particular will be very reluctant to affect the outcome by further tightening policy. Although central banks will continue with the quantitative tightening they have been using to gradually reduce the money supply, the Fed has announced it’s prepared to pivot toward reducing interest rates in the new year.

In other words, the Fed has decided to join the gamble, and endorsed the rally in markets. The new year will reveal if its judgment that it has won the war on inflation is correct. If it isn’t, it will have a difficult job on its hands in the midst of a politically fraught season.