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To cut or not to cut?

  • Hopes are high that 2024 will be a year of substantial policy rate cuts
  • A careful examination of history, however, suggests that premature easing may backfire
  • On too many occasions, “windfall” declines in inflation have been followed by economic and financial instability

An immaculate disinflation?

Last year, the US enjoyed the perfect combination of falling inflation and strengthening growth. There were echoes of the late 1990s, when the words “new economy” were on everybody’s lips. Back then, the Fed felt able to cut rates – fearing the onset of a recession – yet its forecasts proved wide of the mark. The economy and stock market boomed – and then boom turned to bust. Cutting rates today could threaten a similar upheaval.

Cyclical strength limits rate cutting opportunities

If history is any guide, Fed funds will only be able to fall a long way if unemployment rises significantly and the economy goes into recession. Few forecasters foresee such an outcome. If recessionary conditions don’t materialise soon, modest rate cuts today could easily be followed by renewed rate increases tomorrow.

A shift in the transmission mechanism

The (limited) evidence suggests that the many years of zero rates and quantitative easing may have altered household and corporate balance sheets in ways that have reduced the immediate economic sensitivity to changes in policy rates. If so, cutting policy rates too soon may reduce their medium term “bite”, allowing demand to reaccelerate and, in turn, encouraging inflation to ratchet higher.

Seduced by external drivers

Our final lesson comes from the second half of the 1980s. Oil prices collapsed in 1986, apparently ushering in a period of sustained low inflation. Central banks slashed rates in the hope of supporting economic growth. Yet, as demand strengthened in 1987, rates had to go back up again. The October 1987 stock market crash led to a partial reversal but Fed funds eventually peaked at nearly 10%. In truth, inflationary pressures were governed more by the state of the domestic economy – including the balance between supply and demand – than by any short-lived “manna from heaven” external developments. The same, ultimately, is true today.

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