Financial markets resemble toddlers—self-absorbed, focused on instant gratification, prone to tantrums and easily distracted. Both of them love comforting narratives, especially fairy tales with happy endings, no matter how farfetched. Analysts and commentators today are enraptured by the ‘pivot’—significant cuts in official interest rates. International markets have factored in much lower US rates in 2024 and long-term government bond yields have fallen, in anticipation, by nearly 1 percent.
Amusingly, the new narrative reflects a marked shift from the ‘pause’ (stopping rate increases), the ‘skip’ (temporary delays in rate rises), and ‘higher for longer’ (persistence of higher rates) memes that have dominated 2023. There are reasons for scepticism.
First, the change is based on recent comments by US Federal Reserve chair Jerome Powell. The faith is touching given that central bankers failed to forecast the current surge in prices, branded it ‘temporary’ and confessed that they did not really understand inflation. In any case, interpretation of a policy maker’s gnomic pronouncements is problematic. As that paragon of central-bank-speak, Alan Greenspan, told a US Senate committee in 1987: “If I seem unduly clear to you, you must have misunderstood what I said.” Moreover, other members of the US Fed as well as the Bank of England and the European Central Bank have been more circumspect about loosening monetary policy.
Second, global inflation, which would need to fall to allow rate cuts, remains well above the 2-3 percent targets commonly accepted. Recent falls are driven primarily by falls in volatile energy and food prices, which may not continue. While some goods prices remain weak, primarily due to industrial overcapacity in China, rise in wages (note the various labour settlements in advanced economies) are yet to flow through into services costs, which make up 60-70 percent of economic activity.
Inflation may persist at high levels for much longer than expected. There are structural factors. Housing makes up a large portion of measures—generally 20-30 percent—and continued price rises and higher mortgages costs as rate rises flow through will affect this component.
Demand remains high. Strong labour markets and the pandemic savings build-up, which has been underestimated, underpins consumption. The extraordinary pandemic fiscal stimulus—in the US, it totalled around 25 percent of GDP—and continuing government initiatives on infrastructure and the energy transition will boost spending.
Major concerns remain on the supply side. Labour and skills shortages, in part driven by aging populations and retirements during the pandemic, are likely. Raw materials prices, such as for basic construction materials, have risen. Emerging shortages in commodities, especially those needed for new energy sources such as copper and nickel will aggravate pressures. Lack of investment in traditional energy sources, under pressure from activist investors, now constrains supply.
Geopolitical factors are relevant. Ongoing conflicts and ramped up defence spending add to demand, both for labour and materials. But longer-term factors are more concerning. Glib talk of new ‘cold wars’ notwithstanding, the global economic structure is shifting. Great power competition between the US and China will affect supply chains. Sanctions and trade restrictions are accelerating, especially in the area of semi-conductors and technology. Both likely candidates in the 2024 US election—President Biden and former President Trump—are protectionists rather than free-traders. Europe, whose manufacturing sector is struggling, may impose tariffs on Chinese exports of items like electric vehicles.
The shift to greater self-sufficiency—either through onshoring, relocating suppliers or creating alternatives—and increasing inventory levels decreases efficiency, as economies of scale and scope diminish. Restricting agricultural exports to ensure national food security will grow. This will push up costs of many items.
The effects of climate change are complex. Investment in new energy infrastructure and sources exacerbates demand and material and skill shortages. Extreme weather events such as droughts, storms and floods will disrupt logistics. Low water levels are affecting transport links in the Panama Canal as well as the Rhine.
Markets are generally poor at incorporating geopolitical risks. The risk of disruptions to energy supplies is evident as attacks on tankers around the Bāb al-Mandab, which appropriately means the Gate of Tears, disrupt traffic. With over 50 national elections in 2024, an abnormally high number, the risk of electoral surprises and unexpected policy shifts should not be ignored.
One underestimated consequence is the increasing insurance costs and effects on insurability of certain activities.
Overall, the identified factors may not be consistent with easing price pressures. There is also a basic misunderstanding. Inflation measures change and prices may remain at elevated levels. Without inflation falling back within target bands, central banks will find it difficult to justify rate cuts.
Third, policymakers are constrained by asset prices. Expectations of rate cuts are fuelling rises in already-high stock and property prices, increasing the risk of a financial crash. Given increased public disquiet about housing affordability in many countries and high stock market favouring the wealthy, there is increased sensitivity to the effects of monetary policy on inequality.
Finally, current interest rates are hardly high by historical standards. The recent rate rises can be seen as a long overdue normalisation from the emergency setting after the 2008 global financial crisis and the 2020 pandemic.
The contra case is simple. Higher rates have done their job and now they risk a dramatic deceleration. A recession would expose the fragilities of an over-indebted world through unemployment, a collapse in earnings, corporate bankruptcies (now rising globally) and asset price falls. Another version of this argument is that the current rates, if sustained, would make high debt levels unsustainable, including for governments. The US’s public debt servicing costs were 16 percent of its tax revenues in November 2023 and are expected to increase.
The problem with these counter arguments is that weakness in the real and financial economies, with its implications for the supply of the economy’s lifeblood—cheap credit— does not support the high asset prices reliant on assumed rate cuts.
In real life as in the markets, there are few fairy tales and fewer happy endings. Most comfortable narratives are short-lived and end up in pain. It will be interesting to see whether the pivot fable proves to be different.
Satyajit Das,
Former banker and author; his latest book is Fortune’s Fool: Australia’s Choices