The sprint to raise interest rates to levels that cool demand will give way next year to an elevated saunter. The coming phase of tightening will be more nuanced, but no less fraught than what we’ve seen until now. The cost of a misstep will be considerable because the global economy will begin this subsequent stage in mediocre shape.
The main task of central bankers will be to convince people that smaller hikes won’t necessarily lead to cuts. They may well presage a pause, but officials will be at pains to say their task isn’t complete. For investors, this will require attentiveness to subtleties: sifting the data that's most important at any one given moment, which central bankers are talking and how much they matter. Because the path of borrowing costs will become less predictable, there are also significant implications for currencies. Does the dollar's uber-rally continue, can the beleaguered yen get some relief, will China have to work harder to cushion the yuan’s decline?
Traders got a taste of this new world on Thursday when the Reserve Bank of Australia foreshadowed a transition to hikes of 25 basis points after a quartet of half-point moves. Yields on Aussie debt dived while rates on U.S. and New Zealand sovereign debt also retreated. “The case for a slower pace of increase in interest rates becomes stronger as the level of the cash rate rises,’’ RBA Governor Philip Lowe said in a speech. In other words, we can't keep going at this clip for much longer. It isn't sustainable, regardless of the pace of inflation.
The ability to step aside and judge the impact of rapid-fire rate increases is the place officials always wanted to be. Across the globe, they appear to have decided that the sooner they arrive, the better. Tightening that might have occurred in 2023 is now being pulled forward into this year, wrote Krishna Guha and Peter Williams at Evercore ISI in a recent note. As a consequence, the cycle may mostly be over by Christmas, they said. (The firm expects a 75-basis-point increase in the Federal Reserve’s benchmark rate next week.)
That sounds like good news, but the potential for mistakes is significant. Hawk or dove, there was no real argument this year about the direction rates had to travel, nor that the pace had to be reasonably brisk. The differences were mostly at the margins. Hike by 50 or 75? Is a couple of reasonably large steps at a steady clip better than big and still bigger? In the new environment, the choices may be pause, hike, or at least signal an intention to consider a cut—provided inflation is moving the right way. Sounds almost normal, except we haven't had normal in decades.
St. Louis Fed President James Bullard alluded to the prospective shift last week—after signaling support for a third straight 75-basis-point jump at the Federal Open Market Committee’s next meeting on Sept. 21. “We have to get to the right level of the policy rate,” he said in an interview with Bloomberg News. “And then at that point it’s kind of ordinary monetary policy: You might adjust up somewhat because the data came in unfavorably for your goals or keep it the same because you are about on track or decrease a little bit because the data has come in favorably for your goals.”
As extraordinary as the present times seem—inflation the highest in at least a generation, the fastest hikes in decades—the early 1980s were more extreme. For all the comparisons with the era of Paul Volcker, the legendary Fed chief who slayed inflation, the level of rates today is still relatively low and inflation not as high. The federal funds rate reached 20% in early 1980; the upper end of the rate range now is 2.5%. Consumer prices surged almost 15% from a year earlier in March of 1980. Last month, they rose 8.3%, the Department of Labor said Tuesday. (The Fed's preferred price gauge, the personal consumption expenditures index, climbed 6.3% in July from a year earlier.)
Some officials are trying to prepare the ground for variety. “We have our hands completely free,” Francois Villeroy de Galhau, a member of the European Central Bank’s governing council, said Friday. That was a day after the ECB lifted its main rate by three quarters of a percentage point. “Nobody should speculate that this will be the magnitude of the next step—we did not create a new ‘jumbo habit.’” That doesn't rule out another large move; ECB boss Christine Lagarde was careful to keep that in play.