Central banks to “tread carefully” to balance inflation, rate cuts

The latest market analysis from Principal Asset Management for the second quarter of 2024 has warned central banks, especially the US Federal Reserve (US Fed), to “tread carefully” with its policymaking to achieve a soft landing.

The manager’s Chief Global Strategist, Seema Shah, said the final leg of central banks’ wrestle with inflation and this tightening cycle will be “bumpy and unpredictable”.

“Against that backdrop, small surprises in inflation can have significant consequences for the policy path and the economy. History clearly warns against cutting rates before inflation is on a sustainable path back to target. There are striking similarities between U.S. inflation  developments today and those of the early 1970s

“During that period, the Fed had also responded with steep interest rate hikes. After some time, it was anxious to ease monetary policy, cutting interest rates before inflation had fallen back to levels consistent with price stability. The result was a resurgence in price pressures.

“However, the very limited number of successful soft landings also demonstrates the dangers of waiting too long before cutting rates. If the Fed were to keep policy rates on hold at 5.5%, falling inflation would imply a rising real policy rate and, therefore, a tightening monetary stance. As such, keeping rates on hold for too long risks throwing away the strong prospects of achieving a soft landing—the Fed must navigate its policy path very carefully.

In the report, Shah also said the US Fed has indicated it is quite “eager” to cut rates, with the consensus now settling around two cuts this year commencing from September after a volatile ride through market expectations and forecasts.

“The Fed, and in particular Chair Powell, have made it abundantly clear that it wants to cut rates this year. Not only has it been downplaying the importance of recent inflation prints, but upward revisions to the Fed’s growth and inflation forecasts did not prompt any changes to the near-term policy path projection. The Fed continues to expect 75 basis points of cuts this year.

“The strength of the economy means that only one cut is likely required, yet we must take consideration of the Fed’s clear desire to cut rates into account. We have revised our forecast from three cuts to two cuts in 2024, with the first reduction coming in September. The complications of starting an easing cycle just before the U.S. Presidential election does insert significant uncertainty.

“Investors should note that cutting policy rates when the economy is running above trend and while unemployment is still near record lows raises the risk of another inflation wave. The implication is that the Fed’s loosening cycle will be historically shallow, with rates ultimately higher for longer.”