Will rate cuts save the economy?

A new cycle of rate cuts has started across the entire world. The European Central Bank (ECB) has just cut its key rates by 25 basis points for the second time since June. The US Federal Reserve (Fed) is preparing to follow suit on 18 September, with some predicting a cut of up to 50 basis points. And the same trend is at work everywhere, with the exception of Japan.

At the same time, the economy is suffering in a number of key regions. The eurozone and others are stagnating, China – despite growth of 4-5% – remains mired in an endless real estate slump with lacklustre consumption, whilst the US and others are sending worrying signals via a slowdown in the employment market. Will the announced easing of interest rates be sufficient to offset the widespread weakness in growth?

It’s a comforting thought, but an analysis of monetary mechanisms puts paid to a few illusions. Firstly, cuts will be gradual, except in the unlikely event of a sudden economic catastrophe. The consensus currently anticipates cuts at an average pace of 25 basis points at each Fed or ECB meeting over the coming year, i.e. twice a quarter. Patience will thus be required before we see any significant changes in rates.

In addition, rate cuts do not feed through to the economy immediately, as Christine Lagarde pointed out when questioned on this topic on 12 September. There are three distinct phases to the process[1]. Upfront of any monetary policy decisions and guided by the economic outlook and statements from central banks, the bond and forex markets reflect their expectations for interest rates in prices. Similarly, companies and households adjust their production and consumption behaviour based on their expectations for inflation, which in turn depend on the expected interest rate conditions. But at this stage, there is no significant change to the actual financing of the economy, as credit formation is gradual.  When rates are actually cut, there is a real change in the situation of highly leveraged sectors such as banks and areas related to real estate. Lastly, a long time after changes in key rates, most of the economy, the “real” economy that is not simply financial, feels the impact of easing and starts taking on debt. This process can take anywhere from six months to close to two years[2].

This means that current rate cuts will provide little real support for languishing economies for several quarters. That said, the simple fact that central banks now have substantial room for manoeuvre, on the back of favourable developments in inflation, is a form of support in itself, both for the market and the economy. Economic agents can rightly anticipate robust central bank action in the event of acute necessity. This may lift some of the potential brakes on investment, thus reducing the risk of a sharp economic slowdown. The virtuous circle of economic confidence implies that simple belief in central banks’ ability to come to the rescue helps curb the progression of the mechanisms that would make any such rescue necessary.

Final version of 13 September 2024 – Alexis Bienvenu, Fund Manager, LFDE

The opinions cited are those of the fund manager. LFDE shall not be held liable for these opinions.

[1]Monetary policy: identifying the time taken for rate hikes by central banks to feed through into the economy, Y. Tampereau, Caisse des Dépôts et Consignations, 18 April 2023 (article only available in French)

[2]How Long Does It Take for Rate Cuts by The Fed to Percolate to The Economy?, SG Analytics, 8 March 2024