US inflation appears stickier and growth has remained stronger than expected. Thus, a cut in US interest rates in March now appears very unlikely and even the probability of a cut in May has dropped in recent weeks. On the other hand, commercial real estate problems on both sides of the Atlantic have revived market concerns over regional banks, which boosts the case for cutting rates sooner.
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Persistent inflation
Year-on-year US headline and core consumer price inflation slowed by less than expected in January and the monthly rate of core inflation rose. The resulting market jitters around the chance of fewer interest rate cuts drove the Dow Jones and NASDAQ indices down by 1.5% or more on 13 February. European equities fell by 1%.
Other data for January have shown sturdy growth and price momentum. They included the US Institute for Supply Management (ISM) services index, which grew at its fastest pace in four months; non-farm payroll data showing 353 000 new jobs on a seasonally-adjusted basis, and an unexpected acceleration of average wage growth to 4.5% year-on-year. Over 2023, the employment cost index rose by a strong 4.2% YoY.
This raft of figures has blown the idea of the Fed reducing rates in March out of the water; the fed funds futures market has pushed back its rate cut expectation to June 2024 with a probability of 75%.
The US economy looks to be too resilient for the Fed to start lowering rates anytime soon. Nevertheless, the rise in US productivity since the pandemic should help ease concerns that inflation will go up again, prompting a new round of policy tightening (see Exhibit 1).
Other factors at work, however. Conflicts in the Middle East and the Red Sea are increasing the risk of inflation due to energy and supply chain disruptions. Comments from the Institute for Supply Management noted companies saying that the Red Sea shipping attacks and congestion in the Suez Canal were delaying deliveries and boosting price pressures. The ISM prices index leapt to 64, its highest since February 2023.
Asian economies ex China outperformed the developed market economies, with India showing the strongest PMI readings.
Policy easing? Not yet
The combination of resilient demand, tight labour markets, and inflation risks argues for the Fed and other central banks to wait before shifting to policy easing. Last week, the Reserve Bank of Australia kept its policy rate unchanged and noted that further monetary tightening could not be ruled out.
The OECD also warned central bankers that it was too early to declare victory on inflation because growth remained buoyant. According to its latest forecasts, global growth would slow slightly to 2.9% YoY this year from 3.1% last year. However, there are regional differences, with the forecast for US growth revised up by 0.6 percentage points and the eurozone’s growth outlook being cut by 0.3 ppt.
Pressures from commercial real estate
Commercial real estate (CRE) in the US is again reviving concerns about a regional banking crisis. Should one occur, it could bring forward interest rate cuts. Lenders and investors in Japan, Germany and Canada have reported sizable credit losses or write-downs related to CRE problems in the US.
US Treasury Secretary Yellen, Fed Chair Powell and central bank officials on both sides of the Atlantic have expressed concerns over the risks to financial stability posed by CRE. The overall official tone, however, is that it is a manageable problem.
Who will cut rates first?
The current consensus is that interest rate cuts will come in 2024. Two years of monetary tightening have squeezed growth, and CRE problems add to the pressure to lower rates. The links between banks and commercial real estate may impair banks’ ability to extend credit to households and businesses. That could crimp credit provision and eventually weigh on GDP growth.
Nevertheless, financial markets have remained calm. If there are further problems, investors expect the central banks to come to the rescue. Such confidence can be seen in the stability of the benchmark US banking index and in the 10-year Bund yield despite the bad news from regional banks in the US and Germany.
All of which leaves us with one question: Who will cut rates first?
The eurozone’s weaker economic performance and inflation relative to the US suggests the ECB should cut first, but the European Central Bank is likely reluctant to move before the Fed.
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