In the current economic climate, central banks around the world are considering or are already cutting interest rates. This decision is not without controversy, with some critics arguing that such moves may be ineffective in preventing recession or even exacerbate economic problems.
However, as economists at TS Lombard have argued, there are compelling reasons why lowering interest rates is actually beneficial and why central banks’ approach should be viewed in a more positive light.
The belief that raising interest rates had no tangible impact on the economy is a misconception. Interest rate hikes hit interest-sensitive sectors almost immediately. For example, demand for housing fell, real estate investments stalled, and demand for durable goods slowed dramatically.
The global construction sector, in particular, faced challenges, although these were somewhat mitigated by projects that started during the Covid-19 pandemic when supply constraints prevailed.
The initial impact of higher interest rates was evident through “flow effects” – immediate changes in investment and demand for credit. By contrast, “stock effects,” which relate to the impact on debtors’ disposable incomes, developed more slowly.
The muted response in this area during the last tightening cycle can be attributed to the fact that both households and firms restructured their debts, thus preventing a major financial distress despite higher debt servicing costs.
Lowering interest rates would quickly stimulate economic activity. According to the TS Lombard report, interest-rate-sensitive demand should increase immediately, leading to a rebound in housing demand and a revival in construction activity.
Moreover, lower interest rates could stimulate the durable goods sector, providing a boost to global manufacturing. More importantly, a monetary policy shift at this stage could prevent further tightening due to the negative effects of previous interest rate hikes.
In the absence of an immediate rate cut, monetary policy is expected to tighten further as the effects of previous rate hikes continue to build. This scenario could further weigh on economic activity, making the case for a preemptive rate cut stronger.
The impact of interest rate cuts on asset prices depends largely on the context in which they are implemented. Preemptive interest rate cuts, designed to stave off a potential economic downturn, often have a positive impact on risk assets. Such cuts signal a proactive stance on the part of central banks, suggesting that economic stability is a priority. As a result, investor sentiment tends to improve, pushing asset prices higher.
By contrast, cutting interest rates in response to existing economic challenges can have a more complex effect. While it aims to stimulate the economy, it may also signal a deteriorating economic outlook, potentially weakening investor confidence and asset prices.
Early in the year, the prevailing sentiment was that central banks were taking a proactive approach, which supported risk assets. But the subsequent rise in inflation rates has created uncertainty.
Despite the concerns, TS Lombard points out that labor markets have yet to show signs of a sharp slowdown. Employment figures have remained relatively stable, suggesting that central banks may not be lagging behind just yet.
In the past, central banks, such as the US Federal Reserve under Alan Greenspan in 1995, would wait for more tangible signs of economic trouble before adjusting policy. In this context, while a soft landing may be difficult, it is hard to predict anything worse than a mild recession based on current economic fundamentals.