The Federal Reserve’s move to signal fewer interest-rate cuts this year deepens its divergence from peers who have already begun to ease.
The message from the Fed was two-fold: Not only are officials now only anticipating one rate cut this year, compared to the three they projected as recently as March, but they also see its easing cycle bottoming out at a higher level than previously expected, underscoring the era of higher rates is set to stay.
That’s in contrast with the Bank of Canada, which lowered its benchmark overnight rate by 25 basis points to 4.75% last week, making it the first Group of Seven central bank to kick off an easing cycle. The European Central Bank soon followed, lowering its key rate by 25 basis points to 3.75%, while the Swiss National Bank made its move to cut in March.
For the world economy, divergence from the Fed matters. Higher US interest rates stoke dollar strength and will continue to lure foreign capital away from rival economies, especially emerging ones.
The Fed staying on hold raises questions around harmful foreign-exchange volatility and risks undermining progress on getting inflation down, according to analysis by Bloomberg Economics.
“The overall theme for western, developed economies is that we’re on the road to cuts but it won’t all happen at once,” said Kristina Hooper, chief global market strategist at Invesco. “The Fed is not in the lead this time. Last week was historic in that we saw two G-7 central banks cut rates, neither of which was the Fed.”
Fed Chairman Jerome Powell did little on Wednesday to encourage bets on a near-term rate cut.
“We’ve stated that we do not expect it will be appropriate to reduce the target range for the federal funds rate until we have gained greater confidence that inflation is moving sustainably toward 2%,” Powell told reporters after keeping policy on hold. “So far this year, the data have not given us that greater confidence.”
Policymakers see scope for different paths ahead, suggesting there’s space for divergence before it crosses a threshold that would fuel market volatility.
“There are limits to that divergence in interest rates, but we’re not close to that limit,” Bank of Canada Governor Tiff Macklem said on a panel discussion in Montreal on Wednesday.
Such a split is only set to bolster the prevailing trend that has grabbed hold of currency markets in 2024: The high relative yields on offer in the US make investing in American assets — and by proxy the dollar — too good to pass up.
What Bloomberg Economics Says...
“Powell’s signaling that the Fed might hold rates higher for longer prompts questions about how much other major central banks can move forward with rate cuts without stoking harmful exchange-rate volatility and risk undermining progress in getting inflation down. Scenario analysis based on our in-house SHOK model provides answers. Taking the euro as an example, depreciation is likely to have only a small impact on imported inflation. That alone won’t move the dial on ECB policy, though our model shows it remains a channel to watch.”
—Simona Delle Chiaie, economist. For full research, click here
Save for Japan, gains have been pronounced against those economies where benchmark rates have since been cut this year. The euro is down more than 2% versus the greenback, the Canadian dollar and Swedish krona more than 3% weaker, and the Swiss franc is lower by almost 6%.
The yen weakened in Asian trading on Friday after the Bank of Japan decided to stay put on monetary policy and said it would specify the plan for bond purchases at its next meeting. The decision spurred selling of the yen as investors were primed to expect details on cuts to debt buying.
A recent study by Bank of America currency strategists Howard Du and Vadim Iaralov found that this year’s dollar buying — prompted by the relative yield and growth advantage in the US — has largely taken place outside of US hours and been led by investors in Europe and Asia.
“You have a central bank dynamic where the Fed relative to most other global central banks is perceived to be more hawkish,” said Nathan Thooft, of Manulife Investment Management. “Eventually the Fed will begin a cutting cycle like everyone else, but our relative rates are starting at a higher level and we’re starting later.”
Even if the Fed does cut, the moves will likely be limited given that pockets of inflation remain sticky and well above the 2% target, said Jerome Haegeli, chief economist at Swiss Re, who previously worked at Switzerland’s central bank.
“What the market’s short-term thinking misses is the fact that the Fed is likely to cut by much less than what was previously the norm,” he said. “Higher-for-longer remains intact in the US and over time.”
Traders see a high chance the Fed will lower rates in September after a key gauge of underlying inflation posted its smallest annual advance in more than three years. And in what may limit the divergence trend, there’s no guarantee that the ECB or others will have scope to move further as policymakers warn that inflation remains a threat.
“Central banks on both sides of the Atlantic have to be even more stubborn than the inflation,” ECB Governing Council member Joachim Nagel said at the same event as Macklem in Montreal. “This is a similarity that I see.”
And the Fed isn’t the only central bank leaning hawkish. The BOJ is facing pressure to tighten as its currency remains weak, while the Reserve Bank of Australia continues to warn of ongoing price pressures.
“Of course, the other risk is cutting too soon, with inflation picking up again, and rate cuts having to be reversed,” said Solita Marcelli, chief investment officer for the Americas at UBS Global Wealth Management. “Which is precisely why the Fed has been very patient in starting its easing cycle.”
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