Global Financial Landscape and Interest Rate Cuts

By Howard Schneider and William Schomberg
WASHINGTON/LONDON (Reuters)

With key central banks now aligned in cutting interest rates, a real-time experiment is underway exploring how much the global financial landscape has changed since the pandemic. In particular, there is concern whether the easing cycle may be short-lived due to higher underlying rates.

The Federal Reserve’s recent half-point rate cut, larger than anticipated, joins the efforts already started by the European Central Bank, the Bank of England, and others. Analysts suggest this move may have paved the way for the People’s Bank of China to introduce its largest stimulus since the pandemic, with fewer worries regarding impacts on local currency values.

However, the duration and extent of global easing remain uncertain as policymakers assess whether the rates needed to maintain inflation control and economic growth are now higher than the ultra-low rates common before the pandemic.

Officials from Washington, Frankfurt, and London are cautious, admitting they cannot definitively identify a “neutral” interest rate without observing how economic conditions adapt as rates decrease. This task will rely heavily on instinct and intuition as well as math and modeling.

Despite this uncertainty, there is consensus that the neutral rate is likely higher than prior to the pandemic. Eventually, this will lead to more cautious approaches towards future rate cuts. Fed Chair Jerome Powell expressed that the ultra-low rate environment may be gone for good, stating, “it feels to me that the neutral rate is probably significantly higher than it was back then.”

The measures of economic health—such as inflation, employment rates, wage growth, and overall growth—will ultimately help determine the neutral rate level that major central banks aim for. Among them, only the Bank of Japan is tightening its monetary policy as it has achieved certain inflation targets.

Recent Fed projections indicate a median stopping point for interest rate cuts at 2.9% by late 2026, but estimates vary widely across officials. Fed Governor Michelle Bowman notably believes the neutral rate is much higher than previously thought, suggesting the Fed is closer to its theoretical limit.

Changes in Borrowing Costs

How upcoming data and debates manifest will be crucial for resetting global borrowing costs, affecting home loans, car purchases, and business investments. In the U.S., 30-year mortgage rates once hovered around 3% before the pandemic, spiking to near 8% as the Fed tightened. Presently, rates are trending down toward 6%, though declines might not match previous rises. A recent Fed study suggested mortgage rates might not drop below 5%.

In Europe, the ECB’s staff indicated a real neutral rate around zero, considerably higher than rates before the pandemic. The BoE recently cut its rates to 5.0%, with analysts estimating the neutral rate at approximately 3.5%. Governor Andrew Bailey echoed Powell’s sentiment, suggesting that low-rate environments like those from 2009 to pre-rate hikes are likely over due to significant economic changes and shocks that have reshaped global markets.

Jason Thomas, head of global research and investment for Carlyle, remarked that changes in demographics, productivity, and other underlying trends will likely exert more intense price pressures and usher in higher interest rates.

Central banks must navigate their policy decisions in light of these evolving economic conditions, as the world has changed drastically since 2019.

(This story has been corrected to clarify details regarding the euro zone’s neutral rate estimate in paragraph 15.)