On July 6, 2024, Christine Lagarde, President of the European Central Bank (ECB), announced a decision to cut borrowing costs, joining the Bank of Canada in launching a new round of interest rate cuts. This move comes amid expectations that the United States and the United Kingdom will follow suit in the coming months.
These measures were driven by local economic developments. However, additional cuts by central banks, especially the ECB, may be curtailed prematurely due to concerns about how currency markets will react if the U.S. Federal Reserve delays its easing measures.
Adding to this is the over-reliance on a reactive approach in the monetary policy of the Federal Reserve, along with a 2% inflation target, which is considered too low in a world where support for globalization is waning, and the consensus on deregulation and fiscal discipline is rapidly shifting in the opposite direction.
In this context, Bank of Canada Governor Tiff Macklem stated, “It makes sense to expect further interest rate cuts,” based on the current economic outlook.
The ECB tends to be very cautious in its forward guidance, yet it proceeded to cut interest rates for the first time since 2019 before both the Bank of England and the Federal Reserve, despite lagging behind them in the rate hike cycle.
Weak Economic Data
Most recent economic data from G7 countries suggest weaker economic activity than many expected, especially in the United States. Poor data has led to significant downward pressure on commodity prices and government bond yields, although the impact on credit spreads and equities has been limited so far.
Recent data suggests a 35% probability that the U.S. economy will enter a recession, posing significant challenges for the Federal Reserve’s upcoming strategies.
Federal Reserve Approach and Inflation Target
The success of G7 central banks’ rate cuts depends on how well the Federal Reserve manages to transition away from an overly reactive policy approach to a strategic one that anticipates future developments. The Fed also needs to recognize that the appropriate inflation target over the next few years should be closer to 3% to achieve maximum employment.
If the Federal Reserve delays these transitions, the Bank of Canada and the ECB might find that concerns over currency market disruptions limit their ability to implement the necessary interest rate cuts, posing a major challenge for the global economy, which already suffers from fragile growth dynamics and increasing inequality.
