Insight Q4 2024 - Victory lap or obstacle course?

OVERVIEW

With inflation rates close to targeted levels and interest rates starting to fall, it is tempting to say that the central banks’ mission has been accomplished. But caution prevails and risks remain.

The temptation to “declare victory and retreat” must, among central bankers, run high. Since the Spring/Summer of 2022, their primary focus has been on bringing inflation back to target. On the basis of the latest inflation data, that has broadly been achieved. Three-month annualised rates of inflation (which give a more timely picture of developments than the year-on-year rates that are more commonly quoted) are close to 2% (see Figure 1). That is as much of an achievement for the Bank of Japan – which fought deflationary pressures for more than three decades – as it is for the US Fed, the European Central Bank and the Bank of England which battled high inflation for less than three years.

It could be, of course, that this success does not last. Service sector inflation and wage growth are still elevated in the US, UK and eurozone. The current success in controlling inflation owes much to weaker goods prices – notably for energy. However, longer-term inflation expectations (on the generally-preferred measure – inflation over five years, five years ahead) have eased back (see Figure 2). This is a welcome indication that inflation expectations have not become unanchored, as some feared just a short while ago.

Looking ahead, however, the route for the global economy may well resemble more of an obstacle race rather than a central bankers’ lap of victory. Three such obstacles are clearly evident.

Obstacle 1: political uncertainty

After a year of political uncertainty, the main event – the US Presidential election – looms large. The set of policies floated by Donald Trump – imposing 10% additional tariffs on US imports from all sources and 60% on imports from China; deportation of up to 8 million unauthorized immigrants; and greater presidential control over the Fed – are treated with scepticism by mainstream economists. The combined effect of all three would likely result in lower US real growth, lower employment and higher inflation, according to one study.¹ In the UK and eurozone, following recent elections, the direction of policy is also uncertain, particularly given the desire to address high government deficits and debt levels.

Obstacle 2: recession risks

The US has, notably, avoided recession in 2024 but the risks remain. The inverted yield curve – long a reliable indicator of recession – has been signalling a recession for almost two years. It could well be that one finally arrives in 2025. Recessions tend to develop quite quickly when they occur and are not well predicted. The IMF has assessed its own track record and finds that it failed to predict more than 80% of all recessions between 1991 and 2016 (see Figure 3). Even for 2009, the year after Lehman Brothers collapsed, only six advanced economies (and no emerging market and developing economies) had been predicted to enter into a recession; subsequently, almost half the economies in the world did so. Private sector economists fare only marginally better. Maybe chastened by such errors, in late 2022, 70% of economists expected the US economy to enter recession in 2023. That did not happen.

Obstacle 3: deciding on a terminal rate?

Assessment of the appropriate terminal rates for policy interest rates is a third obstacle. For most economies, there is a good deal of uncertainty about the appropriate rate to aim for (see Figure 4). For the UK, for example, it is estimated at between 2.5% and 4.6%; for Japan 1% either side of zero. These estimates are based on the neutral real interest rate (so-called r-star) plus expected long-term inflation (almost universally, 2%). There is much discussion in central banks about the level of the neutral real rate. Before the Covid pandemic, it had been steadily falling for many years. The ‘global savings glut’, identified by Ben Bernanke² and low levels of investment were seen as the main explanation. Now, the combination of ageing and retiring populations (leading to a rundown of accumulated savings) and higher investment needs (notably for the three “Ds” of Digitalisation, Decarbonisation and Defence) are generally seen as putting upward pressure on neutral real rates.³ Some argue that the financial markets’ obsession with prospects for policy interest rates is misguided. After all, no households or businesses borrow at the Fed funds rate or the ECB deposit rate; market-determined rates (such as mortgage rates and corporate bond rates) are more important for consumers and businesses, respectively; and the behaviour of the equity market is often (and 2024 is a prime example of this) disconnected from changes in Fed rate expectations.⁴ The counter to this argument, a forceful one, is that developments in key market rates – notably the US 10-year Treasury yield – are almost fully driven by movements in the three days around Fed meetings.⁵

Too much leverage?

Hitting one or more of these obstacles can, as the events of early August 2024 show, destabilise markets. Then, concerns about weaker US economic growth (Obstacle 2, above) and a change in policy rates in Japan (Obstacle 3, above) led to a sharp drop in the US equity market and a substantial strengthening of the yen. High levels of leverage exacerbated the move, especially a rapid unwinding of the Japanese yen carry trade. Certainly, borrowing by hedge funds and, more generally, in the global economy remain a source of vulnerability (see Figures 5 and 6, respectively). But the rapid recovery from that August shock demonstrates a resilience in financial markets. A resilience which may well be tested again.

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