Understanding Why Central Banks Cut Interest Rates
In recent times, central banks across the globe are either contemplating or actively cutting interest rates. This decision is not without its fair share of debate. Critics argue that these cuts might not effectively prevent a recession and could even worsen economic woes. However, economists, particularly from TS Lombard, emphasize the potential benefits of these rate cuts and suggest that central banks' strategies should be perceived more positively.
Impact of Rate Hikes: A Closer Look
The claim that prior rate hikes had little impact on the economy is a misconception. In reality, these hikes affected sectors sensitive to interest rates almost instantly. For example, housing demand fell, real estate investments slowed, and demand for durable goods decreased significantly. The global construction industry, although somewhat shielded by projects initiated during the COVID-19 pandemic, faced notable challenges.
The immediate effects of rate hikes, known as "flow" effects, were evident as changes in investment and credit demand were seen quickly. On the other hand, "stock" effects, which impact debtors' disposable incomes, developed more gradually. The delayed reaction in this area was largely because both individuals and businesses had restructured their debts to minimize financial strain despite rising debt servicing costs.
Potential Benefits of Rate Cuts
Rate cuts have the power to quickly boost economic activity. According to TS Lombard, demand in rate-sensitive sectors should rise promptly, resulting in a recovery in housing demand and a revival in construction. Moreover, lower rates could rejuvenate the durable goods sector, giving a lift to global manufacturing. A shift in monetary policy at this point could also avoid further tightening due to the cumulative effects of past rate hikes.
Without immediate cuts, monetary policy risks becoming tighter, as the lingering effects of previous hikes continue to build, which could further squeeze economic activity. This makes a strong case for proactive rate cuts.
Influence on Asset Prices
The effect of rate cuts on asset prices depends largely on the context. When cuts are proactive, aimed at preventing potential downturns, they often have a positive impact on risk assets by signaling that economic stability is prioritized. This generally boosts investor sentiment, leading to higher asset prices.
On the flip side, reactive rate cuts, made in response to existing economic issues, may have a more nuanced impact. While they aim to stimulate the economy, they might also reflect a deteriorating economic outlook, which can dampen investor confidence and impact asset prices negatively.
Current Economic Context
Earlier this year, central banks appeared to take a proactive stance, which buoyed risk assets. However, an increase in inflation later added to uncertainty. Despite these concerns, TS Lombard highlights that labor markets have yet to show signs of significant decline. Employment remains relatively stable, suggesting that central banks are still on track.
Historically, central banks like the Federal Reserve in 1995, led by Alan Greenspan, waited for clearer signs of economic trouble before changing policy. Although achieving a "soft landing" might be challenging, given the current economic fundamentals, seeing a scenario worse than a mild recession seems unlikely.
