Bank of England can't cut rates without the Fed

Source: Trustnet

Interest rate cuts have been much talked about all year and some central banks such as the Bank of England (BoE) and the European Central Bank (ECB) seem poised to finally alleviate the pressure on consumers by dropping rates as early as next month.

But there is a finite amount of cuts they can make before they will be forced to stop, according to managers at Aegon Asset Management, who warned that some central banks could be stuck with higher-than-optimal interest rates despite lower inflation and anaemic economic growth.

All will depend on the US Federal Reserve, which opted to hold rates in the 5.25-5.5% range this week following another higher-than-expected inflation print last month.

Stephen Innes, managing partner at SPI Asset Management, noted chair Jay Powell “refrained from explicitly indicating that rate cuts were imminent this year or suggesting that rates had reached their peak, as he had previously stated”.

This week, Darrell Spence, economist at Capital Group, outlined three reasons why the Fed won’t cut rates this year and Nick Chatters, a member of the global rates team at Aegon, noted that expectations for rate cuts have certainly come down since the end of last  year.

“Coming into 2024 we had six cuts priced in, we now have just over one,” he said. This is because the data has been puzzling, with inflation proving stickier than many had hoped.

Indeed, the Federal Reserve has told markets that it will only move if it has confidence that inflation is sustainably moving lower – something that has yet to take place. “In fact it has gone sideways,” said Chatters.

“The problem at the moment is the inflation data is consistently surprising to the upside. If that continues it makes the case for the Fed to keep rates on hold for longer than expected and I would put the possibility of another hike as a non-zero probability, although still low.”

There is also the election to contend with, he added, noting the Fed is in a “lose-lose” situation. Whether it cuts rates or does not, “someone is going to have a problem with it”.

But these dynamics of sticky inflation and political pressure are not evident elsewhere. Indeed, based on lower inflation figures, the ECB has indicated it will cut rates in June.

“The inflation and economic data in Europe looks worse [than the UK] but the trajectory for the data such as the Purchasing Managers Index is rising,” Chatters said, noting that this gives the ECB the ammunition to cut now, although it has yet to lay out its plans post June.

Meanwhile he said the Bank of England “would like to [cut] if the data suggests it can”. He expects a “big drop” in headline inflation next month perhaps even below 2%, which would be “optically important for the market”.

But neither the BoE nor ECB can move much without the Federal Reserve, according to Chatters. “They can start but there is only so far they can push up rates. They can’t keep going without the Fed.”

Vincent McEntegart, co-manager of the Aegon Diversified Income strategies, agreed. It means we could end up in the “bizarre” scenario where UK inflation falls below 2% and economic growth remains relatively anaemic at under 1%, yet interest rates continue to hover around 4.5%.

Moving without the Federal Reserve “would devalue the pound and create inflation”, he argued, as savers would move their money to the countries where they can get the best returns on their cash – in this case the US, where rates will be higher.

This would cause the pound to drop, increasing the costs of importing goods from overseas – particularly commodities which are also priced in dollars.

“A strong dollar causes problems. All commodities are priced in dollars for example, so the price of oil goes up and so inflation rises. It means the Bank of England and ECB are stuck with higher rates because the Fed can’t cut its rates,” said McEntegart.

Chatters added that the ECB and BoE “can get away with two cuts without the Fed” but would struggle to go much further.

He suggested that investors need to consider a new long-term ‘terminal’ rate for interest rates of 3.4% in the UK and 4% in the US – much higher than historical rates and above central bank forecast. “At the moment to get the terminal rate lower you will need to see much quicker progress on inflation,” he said.