Will it be the Matterhorn or Table Mountain? If it were up to Huw Pill, the chief economist of the British central bank, the iconic mountain in Cape Town would become a model for interest rate policy. So: quite steeply up, then (almost) flat for a long time, and then down again. And not, like the famous mountain in Switzerland, straight back into the abyss after a sharp peak.
Pill made the comparison according to the business newspaper Financial Times at the end of August, at a conference in South Africa. Last week, Pills monetary Table Mountain began to emerge a little bit. For the first time since the end of 2021, the Bank of England did not raise interest rates. At the same time, the central bank said it wanted to keep policy restrictive for “sufficiently long” to suppress inflation. In other words: there will not be an interest rate cut for the time being.
A consensus seems to be emerging among central banks worldwide: to really bring inflation down, interest rates will probably not have to rise much, if at all. But interest rates must remain high for a long time. At least a large part of 2024.
The US central bank, the Federal Reserve, also kept interest rates unchanged last week, as did the Swiss central bank. Fed board members did hint at an additional rate hike later this year and at a prolonged high level of interest rates – a scenario that frightened investors on Thursday. US stock prices took a hit, although they recovered on Friday.
The week before, the European Central Bank raised interest rates, although it made it clear that this may be the last time. In any case, the ECB said, the increased interest rates must have a “sufficiently long duration.”
High interest rates are central bankers’ main tool to fight inflation. Borrowing money then becomes more unattractive for citizens and companies. This slows down spending and investments, which also means that price increases must be limited.
Central banks’ inflation target – 2 percent – has not yet been reached, with inflation rates of 6.7 percent in the United Kingdom, 5.2 percent in the eurozone and 3.7 percent in the United States. But it always takes some time – one to two years – before central bank interest rate increases have an impact on inflation. Because the interest rate increases have been going on for about a year and a half and because inflation has been falling for months, the interest rate plateau is now in sight.
Interest rates, which in the wake of the pandemic were just above zero (UK, US) or even below (eurozone), are now between 5.25 and 5.5 percent (US), 5.25 percent (UK) and 4 percent (Eurozone). By signaling that interest rates will not be lowered for the time being, the ECB, Fed and Bank of England want to make it clear that that 2 percent must really be reached before they relax the reins again.
A more erratic interest rate path is conceivable
Still, it is questionable whether the Tafelberg analogy holds up. The interest rate pattern may also become more erratic. Interest rate increases are still conceivable if inflation suddenly soars again. Central banks are still spooked by the wave of inflation that followed the pandemic. They were surprised by both the level and duration of inflation. The lesson from that is: always keep all options open.
It is also conceivable that interest rates will fall again next year if the economy ends up in a (severe) recession. There is a lot of speculation about the latter scenario on the financial markets. In particular, the eurozone and UK economies are starting to perform clearly weaker. On Friday, surveys among corporate purchasing managers indicated declining economic activity.
This is partly due to the effect of interest rate increases. Fighting inflation often hurts economically in the short term, as research by the International Monetary Fund showed last week. But in the longer term it is good for the economy, because it benefits from price stability, the IMF concluded after studying more than a hundred inflation episodes from the past. The IMF’s message to today’s central banks: those who persist win in the fight against inflation, those who “celebrate victory prematurely” lose.
A version of this article also appeared in the September 23, 2023 newspaper.