Stocks march to own tune as other financial markets pare back rate-cut hopes

History has warned that the last stage of returning inflation to central bank targets is often the most difficult

Belgium central bank governor Pierre Wunsch has yet to encounter a microphone he doesn’t like since he was installed for a second term last month – after political wrangling in the country’s seven-party coalition over various posts led to a bizarre 10-day delay in his reappointment.

Wunsch, on the governing council of the European Central Bank (ECB) since taking office in 2019, has delivered speeches in each of the last three weeks, and penned an article for a European financial think tank, to boot.

The tone has grown more hawkish over the period, from calling on February 8th for “more data” before the ECB cuts rates to cautioning this week that official borrowing costs may stay higher “for longer than currently anticipated”.

The ECB governing council may have 26 members but some voices – like Wunsch’s – carry more weight than others. He was among the first around the table in Frankfurt to urge for tighter monetary policy in 2021 when most others, including ECB president Christine Lagarde, insisted a spike in inflation at the time would only be temporary.


The ECB only began to hike rates in July 2022. By then it was on the back foot and had to increase its deposit rate from minus 0.5 per cent to 4 per cent over the space of 15 months.

Euro-zone inflation has fallen from a peak of 10.6 per cent in late 2022 to 2.8 per cent last month. However, a survey published by the ECB on Friday shows consumers are wary about the prospect of price growth easing back to the central bank’s 2 per cent target any time soon. The median expectation of 19,000 adults in euro area countries is for inflation to be running at 3.3 per cent a year from now and that it will be about 2.5 per cent in three years’ time.

This time round, Wunsch is far from an outlier on the governing council. Germany’s Bundesbank president Joachim Nagel and his Austrian counterpart Robert Holzmann on Friday were the latest to temper rate-cut hopes.

Over in the US, the publication this week of the minutes of the Federal Reserve’s monetary policy committee meeting at the end of January noted the risks of moving too quickly to ease official rates from a 22-year high of 5.25-5.5 per cent. US inflation came in at a hotter-than-expected 3.1 per cent in January (compared with a peak above 9 per cent in mid-2022), according to figures published last week.

There are plenty of warnings from history that the last stage of returning inflation to central bank targets is often the most difficult.

“The closer inflation gets back to target, the more pressure there is to ease policy, which raises the risks of moving too early and inflation rising again,” said Henry Allen, a strategist at Deutsche Bank in a report this week.

“Even expectations of future rate cuts can themselves ease financial conditions, which in turn add to inflationary pressures. That’s something we’ve seen in 2024, where the overwhelming consensus is that the major central banks like the Fed and the ECB will make their next move a rate cut rather than a hike.”

When inflation is driven by some sort of shock – such as the unleashing of pent-up demand after the worst of the pandemic, followed by supply chain disruptions, and Russia’s invasion of Ukraine sending energy prices soaring – the immediate effects can ease fairly quickly. The problem is when shocks have second-round effects, as is currently happening.

“Initially, the inflation was caused by goods and more volatile components of the consumer basket, like energy,” said Allen. “But increasingly it is the ‘stickier’ categories such as services that are keeping inflation high, which can be much slower to decline once they move higher.”

More worryingly, the longer price growth remains above target, the more difficult it is to root out, as it leads to higher inflation expectations that become a self-fulfilling prophecy.

James McCann, deputy chief economist with UK investments giant Abrdn, said on a podcast on Thursday that the Fed – which has a dual mandate to achieve maximum employment and keep prices stable – may feel it has the “luxury to be more cautious around the last mile of inflation and hold policy tighter for a little longer” because the jobs market remains strong.

Short-term debt markets, which at the start of this month had been pricing in 150 basis points – or 1.5 percentage points – of ECB rate cuts this year, have scaled back their expectations considerably as they heed increasingly hawkish noises from rate-setters on both sides of the Atlantic. The money markets now expected less than 100 basis points of reductions.

The US debt derivatives markets are now factoring in four quarter-point rate cuts by the Fed this year, compared with six moves predicted a month ago.

Equity markets, however, are marching to a different beat, with the pan-European Stoxx 600 index and Wall Street’s S&P 500 hitting a record high on Friday.

To be sure, this week’s advance has been driven by a buying frenzy after California’s Nvidia, the dominant player in the global artificial intelligence (AI) chip market, posted better-than-expected quarterly revenues.

But even before Nvidia reported, stocks weren’t cheap, with S&P 500 trading at 20 times its component companies’ expected earnings for this year – compared with an average multiple over the past decade of about 16. The Stoxx 600 index in Europe was trading at 14 times its earnings, above its long-term average of 13, amid hopes of a soft landing.

That’s a coveted scenario where inflation and interest rates ease from here, averting a deep global recession.

Will the tricky final mile on inflation catch equity markets out?