Is pessimism about interest rates excessive?
In recent months, markets have revised downwards their expectations of reducing interest rates. The analysis by Steven Bell, chief EMEA economist of Columbia Threadneedle Investments
In recent months, the outlook for the size and timing of interest rate cuts in major economies has become increasingly less optimistic. Indeed, at the beginning of the year markets were expecting around 60 basis points of cuts by June in the US, UK and Eurozone, while now these numbers have fallen to 6, 12 and 22 basis points respectively.
Looking at the outlook for interest rates, we see a very strong downward shift in the US reflecting data suggesting that inflation is no longer falling and remains above target. An important role is played by rent inflation, currently at almost 6%. Furthermore, this effect is amplified by the high weight that housing has in the US CPI, equal to 36%, a value much higher than in other countries. Although the weight of effective rents is equal to 8%, therefore not much different from that of other countries, the United States adds the so-called Owners Equivalent Rent, or what homeowners would pay if they rented their home independently. Therefore, excluding the rent component, CPI inflation has remained around 2% over the past 12 months. If rent inflation were to remain at 6%, the rest of the CPI would need to see zero inflation to bring the total to 2%. In reality, the Fed looks at the consumer personal spending deflator which has a lesser weight on safe haven assets; however, the latter is stable at 18%, which is still too high.
In light of this, the Fed has no plans to change its goals for degrading rents in the short term. However, there remains hope. Ultimately, rents and the cost of other services are determined by wages with a small allowance for productivity. And wage inflation is falling. In the United States there are many wage indices, which currently show a consistent trend. The gold standard is the employment cost index, which is published quarterly. This series has been slowing since peaking at 5% year-over-year last June, and we expect it to be 3 points and headed toward a rate consistent with the Fed's 2% target when the next issue is published at the end of the month. While this is a very difficult choice, we believe this could provide impetus for a quarter percentage point cut in June.
As for the Eurozone, there is a lot of confidence in a 25 basis point rate cut in June, justified by the fundamentals and the words of the ECB members at the last meeting in April. In the UK the situation is a little more uncertain, but the consensus now expects inflation to reach the 2% target, remaining stable for the next 12 months. This means that the Bank of England is likely to follow the ECB's rate cut. Indeed, wage inflation is declining as in the United States, although the starting points are different, and we have not yet seen the full effects of the 10% increase in the minimum wage made during April.
Therefore, we believe the market is showing excessive pessimism about cuts. If this were indeed the case, there would be excellent reasons to expect positive surprises that would create a positive environment for financial markets.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/tassi-interesse-pessimismo-eccessivo/ on Sun, 21 Apr 2024 05:09:42 +0000.