ING’s March Monthly: Deciphering the cycle

More than four years after the start of the pandemic, and more than two years since the start of the Russian invasion of Ukraine, the global economy is still far from normal and continues to search for a new balance.

In terms of inflation and monetary policy, the last four years look like a typical textbook cycle. Inflation surged, monetary policy reacted, inflation came down and now everyone expects monetary policy to react again and to return to normal (or neutral). However, the problem is that the last four years were anything but a textbook cycle. In fact, the global economy and, in particular, developed economies, experienced a series of unusual distortions including lockdowns, supply shocks, one-off fiscal support, pent-up demand and massive rotations in consumer spending, mismatches in job markets, and high inflation which dented spending.

Despite this long series of distortions, central banks have fought inflation in a textbook style. Whether inflation has come down by itself (and base effects) or as a result of higher interest rates remains one of the great mysteries in the current episode of global economics. What is clear, however, is the fact that higher rates will continue to weigh on economic activity and the longer they remain high, the greater the risk of an economic accident.

The problem now is that financial markets still think they are in a typical textbook economic cycle, while central bankers seem to be increasingly doubtful. This is why markets started the year believing in imminent aggressive rate cuts and why they are now gradually pushing back their expectations. Until recently, market expectations about the next central bank steps followed the textbook models, with calls for recession coinciding with calls for a swift and aggressive monetary policy reaction. However, as long as the US stages a soft landing and the eurozone continues to see “only” anaemic growth without falling off a cliff, cutting interest rates at the current juncture will be motivated by avoiding more harm to the economy rather than reacting to a recession.

I think that it is rather unlikely that central banks will go all the way back to neutral interest rates or even below. And this not only has to do with reputational issues and inflation possibly staying more stubbornly above targets than previously thought. There are two other reasons to believe that the upcoming rate cut cycle will be more muted than before. The first is that with ongoing supply-side tensions, the risk is high that any quicker-than-expected economic recovery leads to reflation. The other factor arguing in favour of a more muted rate cut cycle is an increase in the natural interest rate. Here, the jury is still out but initial research papers point to somewhat higher natural interest rates both in the US and the eurozone. Add to that the possible positive impact of AI on productivity and hence growth and it is hard to see rates returning to pre-pandemic levels anytime soon.

Admittedly, any new era will eventually come to an end. Just as the era of “low-for-longer” came to an end, so the “not-so-low-for-longer” era will, too. High government debt and huge financing needs in many economies call for lower rates. It is impossible to tell when the mutual brotherhood of central bankers rethinks its priorities again, accepts somewhat higher inflation and puts more emphasis on growth again. But at some point, they will.

For this year, understanding and deciphering this very special atypical cycle will continue to be an enormous challenge for policymakers, markets and ourselves.

Carsten Brzeski