Central banks have started cutting interest rates

In June the European Central Bank (ECB) quickly followed the Bank of Canada to announce the first cut in deposit interest rates in this economic cycle. We look at what this means and what investors can expect over the rest of the year.

On 6^th June, the ECB cut interest rates by 0.25% to 3.75%, which had been widely anticipated.¹ This is the first deposit interest rate cut in five years and follows the Bank of Canada who cut the day before.

Somewhat counter-intuitively the forecasts for inflation were also revised up slightly and it is now expected to rise to 2.5% in 2024.¹  However, inflation has come down significantly from its peak and is still expected to reach the 2% target in 2025, which means the ECB could cut interest rates further to support the wider economy.

Currently there’s a second cut forecast around September or October and a third one at the beginning of 2025 or even December this year. This reflects the ‘steady as she goes’ approach given there is significant uncertainty in forecasting inflation and economic activity as well as persistence in services inflation.

In contrast to the ECB the Fed kept interest rates on hold at 5.5% on their 12 June meeting - also in line with expectations.¹ The US economy has continued to grow stronger, defying expectations, while inflation has also been stuck above target and remains higher than hoped.

As a result, throughout this year, the Fed has shifted investor’s expectations on when the first rate cut will come. Market participants predict two interest rates cuts of 25 basis points each this year, with the first expected either at the September or November meeting - a significant shift from where we were at the beginning of the year.

The Fed is data driven so it scrutinises indicators, such as payroll numbers, to gain insight to the labour market. These have been strong, while other employment data has been weaker, painting a mixed picture.  Inflation has also been more persistent with inflation forecasts revised up to 2.8% (from 2.6%) which implies interests rates will settle at a higher level – so fewer cuts.

After staying elevated for longer than the US and Europe inflation in the UK has fallen rapidly and in May the consumer price index (CPI) dropped to 2%, the Bank of England’s (BoE) target.  While core inflation, which excludes volatile elements like energy and food, remains high that is also heading in the right direction.

Following the publication of the inflation data the Bank of England (BoE) kept interest rates at 5.25% in their June meeting.¹This was widely expected due to Prime Minister Rishi Sunak calling a general election in July. The BoE prefers to avoid acting around elections as it does not want to be accused of influencing the outcome of an election, which could undermine confidence in the bank’s independence.

The economic data from the UK is mixed. One encouraging sign is that economic activity, as measured by the Composite Purchasing Managers Index, is signalling a growing economy. However unemployment has risen to 4.4% (from 3.8% in November) while the number of job vacancies is in decline.¹

The drop in inflation and comments from the BoE following their June interest rate announcement brought expectations for an interest rate cut forward, possibly in August, which should provide stimulus to the economy and stock markets.

Higher interest rates are restrictive to economic growth as it makes it more expensive for companies and households to borrow which means they have less disposable income. That should cool demand and therefore inflation.

The current levels of interest rates were a response to the spike in inflation we saw in 2022 and much of 2023. With inflation now down central banks are looking to cut rates and ease the pressure on their region’s economy.

The shift to cutting interest rates is likely to be welcomed by financial markets as the policy is ultimately supportive of economic growth.  Cuts could help reduce the restrictions brought on by higher interest rates and avoid tipping the economy into recession, instead steering it on a more prosperous trajectory,

[1] LSEG Datastream / Evelyn Partners