Monetary policy in the eye of a storm

Being a central banker is not all pinstripe suits, leather chairs and mahogany boardroom tables. Cigars are definitely out of the question these days and whiskey is surely only poured out late at night.

Being a central banker is not all pinstripe suits, leather chairs and mahogany boardroom tables. Cigars are definitely out of the question these days and whiskey is surely only poured out late at night. The stakes are still high, however, since monetary policy has a big impact on the economy and financial markets. It can change people’s lives in positive and negative ways. Sometimes, the decisions are difficult and the dilemmas acute.

The past two weeks saw several important central banks make interest rate decisions. Before getting to the two that are particularly important for South African investors, it is worth zooming out a bit. After a synchronised post-Covid hiking cycle, most central banks now have an easing bias, though the number of banks cutting rates every month is gradually declining. A weaker global growth outlook due to US tariffs will keep the cutting going, though there are obviously question marks in the US itself, as discussed later on.

The handful of countries still hiking rates each has unique circumstances, such as Russia and Ukraine’s war economies, for instance. Brazil has pushed interest rates higher to offset loose fiscal policy. This is a country with a history of hyperinflation after all and the central bank did not want to take chances, though its policy rate seems to have now peaked at 15%. The most notable of the hikers is Japan, where rates are gradually rising after being pinned near zero for more than two decades. The Bank of Japan left rates unchanged last week, but its forecast of persistent inflation implies that it will raise rates again later this year.

Chart 1: Global central bank interest rate decisions

Source: cbrates.com

The why and how
Most central banks these days aim to maintain a low and stable inflation rate around a specific target rate, 2% in the case of developed countries. Inflation targeting in turn is premised on anchoring the public’s expectations of future inflation, so that their price-setting behaviour matches the target (though there will always be cycles). This then rests on the central bank’s credibility, since people need to believe that it will act if required.

Changes in central bank policy interest rates directly impact commercial banks, either because it impacts central bank lending to banks, or the rate at which banks lend reserves to one another. These are very short-term rates, usually overnight, but they are important enough for interest rates to rise and fall in the broader economy with central bank policy rates, though not always one-for-one. The higher the interest rate, the more firms and households must cough up every month to repay their loans. Higher rates also discourage new borrowing. Both of these effects dampen demand in the economy, though savers will benefit. This also ripples through financial markets, since higher short-term interest rates offer competition to riskier bonds and even riskier equities. There is also the indirect impact, since a weaker economy will weigh on profitability of companies. When the central bank lowers its policy interest rate, the process operates in reverse.

There are market and economic conditions that can blunt the impact of the central bank’s decisions or amplify them. One of these is that borrowers sometimes have the benefit of fixing their loan rates for a period which means they are not affected by central bank decisions. We saw this in the US housing market in recent years, where homeowners could lock in low Covid-era mortgage rates and felt little pain from the post-pandemic surge. European homeowners, on the other hand, mostly have floating rate mortgages and were squeezed when rates went up but benefitted immediately when rates fell. The same is true in South Africa.

Fed pressure
All central banks are also not equal. In a dollar-denominated world, the US Federal Reserve (the Fed) is the most important. The Fed is also somewhat unique in having a dual mandate, given to it by Congress. Alongside price stability, which it expresses as a 2% inflation target, it must also aim for full employment.

It now faces two challenges. Firstly, President Trump’s tariffs threaten to pull the dual objectives in different directions, since there will be upward pressure on prices and downside pressure on employment. The price increase will probably be once off, but that is not guaranteed. Similarly, while unemployment remains very low, 4.2% in July, it might start rising as the tariffs and other headwinds are fully felt. (We’ll discuss the tariffs and their global impact in more detail next week). Faced with this dilemma, the Fed has not cut interest rates this year, including the Federal Open Markets Committee meeting last week. Notably, however, two FOMC members voted for a cut.

Fed Chair Jerome Powell explained that since inflation is further away from the target than unemployment - its preferred inflation measure was 2.8% in June - the focus of monetary policy must be on the inflation side of its dual mandate. Therefore, a somewhat restrictive stance is still warranted. Should unemployment start rising from current levels, the balance would tilt towards an easing bias. The weak hiring data out on Friday after the FOMC meeting suggests this is still likely to happen later in the year.

Since interest rates work with a lag, there are risks to waiting too long and cutting too early. This is an unusually difficult moment.

President Trump has different ideas, however, and he has piled pressure on the Fed to lower interest rates. He has not only given Powell unflattering nicknames, but also accused him of mismanaging renovations at the Fed’s headquarters. Powell, meanwhile, is trying to shield the Fed from political interference. Trump seemingly wants lower rates so that the government can save money on its substantial borrowings, but it could be counterproductive if longer-term interest rates rise, which would be the case if markets fear that the Fed will lose its independence and be soft on inflation. As chart 2 shows, longer-term government borrowing costs (the 10-year Treasury yield) are correlated to the short-term Fed policy rate, but they can and do diverge, depending on the market’s outlook for future inflation and interest rates.

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