Central banks’ latest tune: Should I stay or should I go?

The sound check’s complete, the opening act is finished, and the stage is set.

East of the Atlantic, inflation has fallen toward the ideal target. Wage growth has proved less intense than feared. Interest rates are roughly 2 percentage points above the so-called neutral rate – a benign sort of level that doesn’t encourage or discourage borrowing. The European Central Bank (ECB) and the Bank of England (BoE) are ready to take the stage and shred some interest rates, with the curtain (probably) rising in June.

However, the lead singer – the US – is out of tune: with a resilient job market, stronger-than-expected consumer activity, and stubborn inflation, it doesn’t seem keyed up for aggressive rate cuts.

Now, we think the US Federal Reserve (the Fed) will cut this year, but if the first quarter’s sluggish economic growth gets an encore, the extent of those cuts will be subdued.

And that’s “The Clash” facing central banks: if the Fed stays, can the ECB and BoE go? Or, more specifically, if the Fed doesn’t cut by much, will that tone down the cuts from the rest of the central bank band?

If I go there will be trouble

Europe and the UK are two distinct economies, of course, and their central banks are independent of the Fed. Still, it’s no small matter that they may be plotting different courses from the US.

Question 1 for the ECB and the BoE may be this: is the story of US economic resilience happening in a vacuum? Or will Europe and the UK catch up?

We believe America is out on its own. The structure of the US mortgageindustry – where most borrowers lock in a lending rate for the entire life of the loan – means it takes much longer for an interest rate hike to affect the average consumer. And there’s still plenty of economic stimulus at play in America: the Inflation Reduction Act was, after all, really a government spending splurge. And that’s all helped beef up the resilience of the world’s biggest economy.

Question 2 might be: can these two central banks take the stage before the Fed?

And the answer to that is: yes, of course. They’ve done it before, and they can do it again.

We see the ECB cutting its key rate next week, regardless of what happens anywhere else. The BoE, on the other hand, isn’t as clear-cut, but with inflation heading lower and the job market starting to weaken, an early summer interest rate cut seems like a good call.

Question 3 is undoubtedly: how often and how deeply can the ECB and BoE cut rates if the Fed hasn’t even reached for scissors?

Markets are wondering about this too. If the Fed’s rates stay high and Europe’s go low, that will have a huge impact on Europe and the UK. All else being equal, when one central bank cuts more aggressively than another, the value of the cutting central bank’s currency falls. Both Europe and the UK are import-heavy economies, so a weaker euro or pound is far from ideal: it tends to lead to “imported” inflation.

If I stay it will be double

Still, delaying or minimizing those interest rate cuts would come with its own set of difficulties.

The trouble comes from keeping rates too high for too long. The UK and eurozone economies have reason to be optimistic right now. But those high interest rates will dampen growth.

Elevated inflation is no good for anybody, but neither is the stunted growth that comes from overly tough monetary policy. Like the Fed, the ECB and the BoE both have inflation-targeting mandates. Both were too slow to raise rates in 2021 as inflation shot to unreasonable heights, for fear they’d overdo it and shatter their economies. They should not make the same mistake on the way down. If economic conditions warrant rate cuts, they should cut.

On balance, we believe the risk of a delay for the BoE and ECB outweighs the risk of going it alone.

Well, come on and let me know

The market doesn’t entirely believe that the ECB or BoE will step out on their own.

Investors are betting that the ECB will deliver five cuts by the end of 2025 – just one more than the BoE and the Fed. And, sure, the bloc’s central bank can deliver more rate cuts than the Fed. But the UK should not have the same number of projected cuts as the US: the two economies are in two very different places.

The latest round of UK jobs and inflation data were plenty of proof of that. The overall “headline” inflation rate came down, but services inflation and wage growth were still stubbornly high.

What’s more, the UK labor market has been weakening at pace. We expect wages will fall, and that services inflation will fall with them.

Thing is, our friends at the BoE aren’t covering themselves in glory when it comes to communication. As market participants, we don’t expect a running commentary, but confusion affects credibility. The BoE seems confused.

This indecision’s bugging me

The next couple of weeks and months should bring some much-needed clarity.

In the US, we’ll find out whether the first quarter’s economic growth was a blip or the start of a trend. And that will give investors a better idea of when the Fed might cut rates – and by how much.

In the EU, we’re confident that the ECB will reduce rates in June.

Finally, in the UK, the next batches of data should give us – and the BoE – more confidence that the inflation battle is nearly won.

So you gotta let me know – should I stay or should I go?

We see no reason why central banks in Europe and the UK can’t get ahead of the Fed. We still expect the Fed to cut rates this year, but the inflation dynamics in the US are different from what’s being experienced on the other side of the Atlantic. So the ECB and the BoE should have no issue following the immortal words of Joe Strummer: they should go.

–Written by abrdn Investment Director Matthew Amis, Investment Manager Alex Everett, Investment Director Tom Walker, and Head of Nominal Rates Aaron Rock.

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