Opinion
Central bank rate cuts: Ask why instead of when and to what extent
Summary
- The US Fed looks set to ease its policy rate soon. RBI might follow with a cut. When and how many basis points are under hot discussion in markets. But it’s better to grasp what drives monetary policy than obsess over the timing and quantum of a pivot.
The focus of market players and borrowers has turned towards monetary policy in the US, particularly the two questions of when and by how much will its central bank, the Federal Reserve, cut the US Fed funds rate.
Anticipation of imminent cuts rose after the Jackson Hole huddle of central bankers and economists, an occasion that market participants across the world were watching for cues.
“The time has come for policy to adjust," Fed chair Jerome Powell said in his speech, adding that “the direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the balance of risks."
Futures markets are now pricing in a 100% chance of at least a quarter percentage point (25 basis points, i.e.) rate cut by the US Fed in September, and have raised the odds of a potential 50-basis-points cut to about one-in-three. However, it is more important for borrowers and markets to focus on the question of ‘why,’ rather than ‘how much’ and ‘when.’
Also read: The Federal Reserve's policy pivot poses a challenge for RBI
A clearer understanding of the underlying reasons can help understand the evolution of the America rate cycle better.
So, why would a central bank or the Fed cut rates?
The first question to ask is: Is the central bank confident of having won the battle against inflation? Powell expressed confidence that there was “good reason" to believe US inflation could fall further without damaging the economy and that the Federal Reserve can still sustainably meet its 2% goal.
That would warrant a shift to neutral-rate territory, which was estimated at 2.55%. Although the risks around inflation have become more balanced, the band of uncertainty is uncomfortably high and the Fed is still not at a juncture where it can emphatically claim to have quelled inflation for good. In that case, a measured rate cut of 25 basis points is more likely.
The second question is: Going forward, is the central bank fearful that the economy is at the risk of faltering? Recessions don’t always come with a flashing red signal. A wait-and-see approach can be damaging because recession risks can spring up on policymakers and by then it may be too late to act.
If this indeed is a big concern, then another round of weak jobs data in the US could tip the odds in favour of a 50 basis points cut and potentially result in quicker and deeper easing in this cycle.
The third point is about consistency. The reason rates were raised aggressively by the Fed, starting 2022, is that inflation kept rising. Hence, shouldn’t rates fall in sync with a deceleration in inflation?
A gauge that the central bank prefers to track inflation most recently showed the rate at 2.5%, down from 3.2% a year ago and well off its peak above 7% in June 2022. If central bank reactions to inflation are inconsistent, it will confuse stakeholders and also hurt its credibility.
Also read: RBI MPC Minutes: Growth impulses allow policy to focus on disinflation, food inflation sticky to core; 5 key highlights
Lastly, are there political reasons for rate cuts? It would be remiss not to mention politics, the elephant in the room, given the US presidential election scheduled this November. Many expect the outcome to have a heavy influence on the path of Fed policy, not just now, but also through the course of 2025.
It could put the spotlight on government debt levels and fiscal profligacy and also reawaken concerns around protectionism and trade tariffs, given that the easing of supply-chain bottlenecks has been instrumental in helping to bring down inflation from its post-covid highs.
All of this brings us to the question of what would the Reserve Bank of India (RBI) do? Governor Shaktikanta Das has so far been hawkish and emphasized the need to ensure that inflation progressively aligns with India’s 4% target.
The Indian central bank’s assessment is that growth is strong and headline inflation has moderated unevenly from its peak. It remains wary of the elevated food price momentum and expects inflation to rise in the third quarter as favourable base effects taper off.
RBI surveys expect a pickup in retail prices in the second half of this year and also hint at household inflation expectations having gone up. All that is in the backdrop of strong gross domestic product (GDP) growth momentum.
However, what if India’s underlying growth momentum starts to wane? Global growth is moderating, as we can make out from GDP data and industrial output, as well as Purchasing Managers Index readings and commodity prices. In India, RBI has lowered its GDP forecast for the first quarter, albeit by only some 10 basis points, after a slew of successive upward revisions.
Asset markets are currently pricing in just one RBI rate cut during the course of fiscal year 2024-25.
Also read: Powell ignored the elephant in the Fed’s Jackson Hole lodge
The central bank has been evaluating policy trade-offs carefully. However, a sharper-than-expected softening in the domestic growth trajectory, weakening of consumer confidence, the rising cost of persisting with high real rates for longer and a decisive turn by the US Fed could and should nudge the Reserve Bank of India towards a pivot on its stance and eventual rate action—and why not?
These are the author’s personal views.
