Why central banks are so reluctant to cut rates

Should tight financing conditions that are thwarting economic growth be lifted? As inflation keeps plummeting, cutting rates is a question of «when», not «if».

The euro area economy has experienced 18 months of stagnation, with growth rates hovering around and even dipping below the 0% mark. Its counterpart over the Atlantic, although performing far better, can attribute much of its success to a healthy dose of government subsidies – unsustainable, to say the least.

As for inflation, the record-high figures witnessed across the world are all but an uncomfortable memory. Strong disinflation has persisted thanks to tight financing conditions and to recovering supply chains following the original energy shock. Global demand remained lulled, providing a sigh of relief to policymakers by keeping demand-pull inflation in check. Moreover, some of the eurozone’s largest economies have as of recent reported falls in inflation figures that exceeded forecasts.

To recapitulate: languid growth coupled with inflation slowly nearing its elusive 2% target. And yet, interest rates remain at a record high. The US Fed is keeping rates at a two-decade high, whilst the ECB’s rates are unprecedented. Something is not adding up, so what gives?

It all comes down to inflation inertia and underlying price pressures. In other words, the labour market. The labour market is running incredibly hot in many developed economies, with unemployment rates standing at record lows. Despite this, many open positions are being left unfilled, resulting in falling labour productivity figures that are holding back growth.

With high employment come cost-push concerns as workers gain stronger leverage to ask for higher wages. Although the “worst” bouts of growth in collective wage agreements have most likely been overcome, higher operating costs for firms risk spilling over to consumers. Labour-intensive services inflation still stands an entire percentage point above overall inflation.

This risk of inflation rebounding is a lifeline hawkish policymakers are holding onto. As the finish line of the fight against inflation looms over the horizon, risking a flare-up in prices due to premature monetary loosening could bear reputational repercussions for central bankers. Rate cuts are imminent; struggling economies will have to hold on for just a little longer.

Update: the ECB lowered the three key interest rates by 25bps on June 6th 2024