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IMF warns central banks against fuelling market hopes of rapid rate cuts

Investor expectations of looser monetary policy could fuel another flare-up of inflation, says Gita Gopinath

Gita Gopinath, the first deputy managing director of the IMF, said inflation is set to decline less sharply than it did last year because of tight labour markets and high services inflation in the US, euro area and elsewhere. Photograph: Stefan Wermuth/Bloomberg

Sam Fleming and Martin Arnold
Thu Jan 18 2024 - 10:48

A top IMF official has warned central banks need to move cautiously on cutting interest rates this year, as market expectations of looser monetary policy could fuel another flare-up of inflation.

Gita Gopinath, the first deputy managing director of the IMF, said inflation is set to decline less sharply than it did last year because of tight labour markets and high services inflation in the US, euro area and elsewhere.

This points to a “bumpy” path towards lower inflation, she said, suggesting official rates should not be lowered until the second half of the year.

“The job is not done,” Ms Gopinath said in Davos, Switzerland. “[Central banks] must move cautiously. Once you cut rates, it solidifies expectations of further rate cuts and you could end up with much larger loosening – which can be counterproductive.”

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“Based on the data we have seen, we would expect rate cuts to be in the second half, not in the first half,” she said.

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Markets sold off on Wednesday as European Central Bank president Christine Lagarde warned rates are unlikely to start falling this spring, while UK inflation was higher than expected.

While headline inflation fell rapidly last year as supply shocks in energy and other markets unwound, strong labour markets are keeping services price inflation stickier.

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US officials have tried to damp market expectations that they could cut rates from their current 23-year high of 5.25 per cent to 5.5 per cent as soon as March, with Federal Reserve board member Christopher Waller this week insisting policymakers should “take our time to make sure we do this right”.

Yet the gap between Central Bank and investor expectations persists, with markets still expecting six quarter-point cuts beginning in the early spring, compared with rate-setters’ forecasts of three later in the year.

“What we think some in the markets have been missing – or not putting enough weight on – is the central banks’ shared fear of starting too soon and having to stop or reverse course,” said Krishna Guha, vice-chair of US investment bank Evercore ISI. This meant central banks were likely to be “a bit late” relative to market expectations of rate cuts, he added.

Ms Gopinath said easier financial conditions after the market rally in recent weeks risked undermining “the forces that would drive demand down”. As a result, efforts to bear down on inflation with high official interest rates could be dented. Central bankers, she said, should not add further fuel to the situation by adding to speculation over rate cuts.

This meant treading cautiously, given labour markets are still “strong” in the US, UK and euro area, potentially underpinning services inflation.

The IMF last year warned history is littered with episodes of central banks indulging in “premature celebrations” when they relaxed after an initial fall in inflation, only to find price growth went on to plateau or to start heading higher again.

Hopes that the Bank of England will soon ease policy suffered a setback on Wednesday as official figures showed headline inflation accelerated to 4 per cent in December – the first rise in the inflation rate since February. UK services inflation accelerated to 6.4 per cent in December from 6.3 per cent in November.

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During meetings at the World Economic Forum, Lagarde said the European Central Bank would only have the information it required on wage pressures by “late spring” and that such data would be necessary before any decision to lower borrowing costs.

Her comments jolted markets, which had fully priced in a cut to the central bank’s record-high benchmark interest rate of 4 per cent by April.

Annual price growth in the bloc slowed from a peak of 10.6 per cent in October 2022 to a two-year low of 2.4 per cent in November, before picking up to 2.9 per cent last month after the phasing out of government energy subsidies.

Lagarde warned inflation was still too high in the labour-intensive services sector – registering 4 per cent in December – highlighting her concern that too-strong a catch-up in wages may keep price pressures too high after pay per euro zone employee rose 5.2 per cent last year.

“Short of another major shock we have reached a peak” in interest rates, she said. “But we have to stay restrictive for as long as necessary” to ensure inflation keeps falling. “The risk would be we go too fast [on rate cuts] and have to come back and do more [rate increases].”

Klaas Knot, head of the Dutch central bank and a member of the European Central Bank rate-setting governing council, backed up her comments, telling CNBC on Wednesday: “The more easing the market has already done for us, the less likely we will cut rates, the less likely we’ll add to it.”

“Market pricing, in our view, is overly aggressive in terms of rate cuts,” said Andrzej Szczepaniak, an economist at Nomura. “Our belief is that the ECB is more likely to begin cutting only in June, allowing it more time to assess the medium-term outlook comprehensively for underlying inflationary pressures.”

Additional reporting by Claire Jones in Washington - Copyright The Financial Times Limited 2024

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