Reuters World News - Ready for rate cuts? The gap between the Fed and Europe

Episode Date: December 23, 2023

A gap has opened up between the Federal Reserve and major central banks in Europe over interest rates. After two years of hikes, the Fed is ready to start talking about rate cuts. The European Central Bank and the Bank of England aren’t there yet. The markets, meanwhile, seem to be getting ahead of everyone. Join our economics correspondents as we explore what this all means for consumers on either side of the Atlantic. Visit the Thomson Reuters Privacy Statement for information on our privacy and data protection practices. You may also visit megaphone.fm/adchoices to opt out of targeted advertising. Learn more about your ad choices. Visit megaphone.fm/adchoices

For the past couple of years, most of the world's central banks have been in a race to beat inflation. It's been a relentless cycle of interest rate increases, pushing borrowing costs in some places to record highs. Now the Fed is saying, enough. 2024 will be the year of falling rates. Across the Atlantic? Well, central bankers in Europe, they don't talk about rate cuts. At least not yet. On this special podcast, we look at the gap that's opened up in global monetary policy.

what it says about the United States and Europe and what it means for consumers on either side of the pond. I'm Howard Schneider in Washington, D.C. I'm Mark John in London. And I'm Carmel Crimmons in Dublin. I'm joined today by two reporters who cover monetary policy in the United States and in Europe. Our Federal Reserve correspondent Howard Schneider is a familiar voice for listeners. He keeps us updated on all the goings on of the Fed and has been covering that central bank for 10 years. Mark John is our European economics editor. He's been covering the Eurozone since before there was even a euro. Thanks to you both for taking the time to talk to me. Sure.

Pleasure. So, Howard, we're on the cusp of a new year, but we're also on the cusp of a new trajectory for interest rates in the U.S. So it seems like cuts to borrowing costs are in the offing. Has the battle on inflation been won? Well, in the U.S., I'd say kind of it has. If you look, the headline rate's still up there, 3%, there's 3% plus. and I'll all refer to it as elevated and risks are still out there.

But you know, on a three or six-month basis, core inflation in the U.S. down to two and a half percent if you annualize the monthly rates. That's really within spinning distance of their target. And moreover, and I think this is what probably pushed them over to the edge is a year driving to a close, producer price. Showing a lot of disinflation still in the pipeline. You see rents actually dropping in many parts of the country.

there's a lot in the pipeline that makes them think that this disinflation progress is going to continue and that they're going to get back to target really faster than many of them expected. And so we're going to see a drop in interest rates in 2024, right? You are. Now, the interesting thing here is that this seems to be kind of calibrated to march in step with inflation on the way down. If you think about, is the Fed keeping pressure on the economy still, the answer is yes. Their policy rates near five and a half percent. That's well above what they see as the long run neutral rate. So policy is very restricted right now. It's putting pressure on the economy. And even if they follow through with a three-quarter point rate reduction they see over the

course of this year, it's still going to be restrictive. It's still going to be leaning on the economy and pushing down prices. So yes, lower rates. But part of that is to kind of bank, and mark the progress they've had in bringing inflation down from these 40-year highs. It's not stimulating the economy. It's not meant to boost people's animal spirits. It is meant to take some of the pressure off, but really their level of restrictiveness is staying about constant through the year. So people shouldn't go reaching for their credit cards quite yet, right?

It's not like back to the good old days. Well, no, and you know, you might think we're not going to get back to the good old days. Look, here's the thing. There were some odd consumer behavior. You're on, let's say unexpected consumer behavior through the pandemic. A lot of the money that went to people's bank accounts, we know they spent it. There's a lot of debt pay down, too. So reach for your credit card.

I don't know. Do you ever want to reach for your credit card? Some people need to. More people are having to. Default rates are going up. There is pressure on the consumer right now. So, yeah, look, it's going to be cheaper to buy a house next year in terms of the interest rate than it was this year. No question about that.

It's going to be cheaper the year after that. It depends on, you know, you're fine. financial position and your risk behavior. It's a very different picture in Europe, Mark, isn't it? Central banks there are pushing back on the idea of imminent rate cuts. They seem to be sticking to the mantra of higher for longer. I mean, we even had the Norwegian central bank even raising rates this month. What's going on?

Yeah. I mean, certainly high for longer, if not higher for longer. I mean, they have said that, broadly speaking, this is the end of the rate hikes. But yes, I mean, they're still very, very nervous about the picture for inflation. in 2004. So, you know, at the ECB's last press conference of the year, Christine Lagarde, basically rang out this long list of risks to the inflation picture. And there's the geopolitical risk.

I mean, Europe being so close to Ukraine and what's going on there and the sort of possible kind of rises, you might get energy prices if there's an escalation in that conflict. She even mentioned things like extreme weather, which could have an impact on the kind of the harvest we get in early 2004 and beyond, there's potential price pressures. But the big one in Europe is that they don't actually know what's happening in the labour market and what's happening to wage costs. So we'll have, as usual, a round of wage bargaining in the European Spring, and really the ECB for one wants to wait and see what happens there.

There's a kind of an idea that after many years of very moderate, if not stagnant, wage, growth across Europe, that workers really want to catch up. And that catch up then could be seen in higher wage demands, which in turn will potentially push companies to start bumping up their prices as well. That's the dynamic they don't understand. And they are very keen to get any more information on that before they start talking about rate cuts. So it's going to take a while before they're kind of comfortable with that idea. And in the UK, it's probably an even more difficult picture. Yeah, I mean, so in the UK, inflation is actually still somewhat higher than is in the Eurozone, and it will be so next year. And we're talking about quite a complex kind of outlook there, right?

I mean, for one thing, things to do with Brexit, things to do with falling productivity, also the number of workers that have left the workforce and so on, that's kind of causing supply constraints, which could potentially keep inflation high, keep stackflation, very much in people's minds. And then, of course, you've got the election, right? So that could take place in autumn of next year, but the way things are going on, the politics, who knows, it could be earlier. I'm hearing talk of possibly even May of next year as well. And sure enough, the Prime Minister Rishi Sunak is talking about tax cuts going into that election, which is a sort of fiscal impetus that policymakers will also have to take into account

when they're deciding what's happening to rates as well. So yeah, hugely complicated. Speaking of elections, Howard, if things are looking better economically in the U.S., is this going to give a boost to Biden in 2024? Central banks don't like to get tied up in politics. And certainly if Donald Trump is the Republican nominee, he nominated J. Powell to be Fed share and that quickly turned on him because Powell was raising rates when Trump didn't think they needed to be raised. And he was very outspoken about that.

So should we come into the summer, into the fall with the Fed cutting rates, reducing borrowing, costs, easing up on financial conditions, where you're going to hear a lot about that from probably whoever the Republican nominee is, but certainly if it is Donald Trump, you'll hear it from him in spades. So is it going to turn things for Biden? Listen, he was the beneficiary of good timing when it came to the pandemic and the vaccines. He inherited an economy that was getting ready to reopen in a forceful way because people were becoming more safe and less scared due to the vaccines that were developed the year before and rolled out right as he was going to take office. He may have some tailwind coming in the form of improved sentiment, a growing economy, you know,

one and a half percent, which is what the Fed sees for 2024 is not great, but it's not that far below what the trend potential is for the U.S. And if you clock in an unemployment rate of 4 percent and reasonable wage growth, yeah, I think you could get an inflation lower back to target. I think, yeah, he could have some boosts from all this. Powell, of course, hasn't made life any easier for the ECB's Christine Lagarde or for the Bank of England's Andrew Bailey, right? Absolutely not. No. I mean, so basically there's this big disconnect that's taken place between where the Bank of England and the ECB are guiding people that rates will be over the next couple of years and where markets are betting that they will be huge. So your markets are, I think broadly at this stage, are looking at about 150 basis points of cuts by the end of next year.

For the ECB, for example, you know, and the ECB, sort of saying, please don't even talk about rate cuts right now. So you've got this disconnect. They are partly, let's face it, to blame for it themselves because they were burnt a couple of years ago by not really understanding what was going on to inflation. So, yeah, when you have Powell coming out and being as dovish as he was in the Fed's last month. meeting, yeah, for sure. That adds to the kind of impetus for markets to start betting on those cuts, and it makes it kind of harder and they have to be more explicit in their language about pushing back. There's also a disconnect, isn't there, between the markets and the view of what the Fed is going to do? Like, the markets just seem to be so aggressive in their expectations for rate cuts.

Right. What is going on there, Howard? So, yeah, markets are really speeding ahead of this. And the question is whether, you know, sort of what the heck is going on? Part of it's probably a rotation back into equities. No one wants to miss the start of the next bull market. But the issue for the Fed now is whether they're going to have to sort of ratify these market expectations or start to rein them back in a little bit because what's happened since the most recent Fed meeting has gone way ahead of what the Fed expects to happen. It's up is on the order of crisis level changes and bond rates. But there's no real crisis out there. So they're going to probably have to be a little bit careful with how this is managed over the next few months this coming turn to rate cuts because

the markets have kind of sped ahead. It's fascinating, isn't it? Because there's kind of the animal spirits on the markets. But then if you look at Main Street, consumer sentiment has only recently started to pick up. And, you know, that's with the labor market in pretty good shape. You know, stocks are up. Right. And now we've got interest rate cuts in the offing. So presumably we're expecting this sentiment to improve. Well, so this is surprised us over. and over and over again. And it was an interesting piece of research from the Chicago Fed a couple of weeks ago that really demonstrated. And other people have pointed this out, but they quantified it yet again. It used to be the labor market, the unemployment rate had a very direct link with

the sentiment indexes, consumer sentiment, business sentiment, CEO sentiment. That's been completely severed by the pandemic. And there are a lot of working theories about this. Maybe people expect low unemployment now so they don't really care if it's low because that's considered to be the norm in the U.S. Now, do you start to get a turn? Inflation is coming down. Wages are rising faster than that. Certainly the people in the White House and Treasury Secretary Yellen, others like that, feel that they're on the cusp of this, that, you know, what's happened over the last

couple of years, from the shock of the pandemic to the shock of inflation, to the shock of interest, high interest rates higher than most people have seen in their life. many people have seen in their lifetime, is all going to take some time to pass, right? 2023, there were a number of shocks that really moved in the Fed's direction, that moved towards a more normal U.S. economy. And they're really surprised to the upside. Mark, the citation in the ECB's latest statement about rising labor costs, direct opposites been happening in the U.S. because of unexpected jumps and productivity. Late-unit labor costs are falling, have fallen this year in the US. And that's a big reason why the Fed's on a bit of a different path. They've just gotten,

they've gotten shocks in a different direction this year. Twenty-two is the year when everything broke against them. Twenty-twenty-three was the year when really everything, labor supply, good supply, productivity, consumer resilience, all broke in their favor. I would add to that, actually, I mean, the situation in Europe is actually a little bit more complicated because you've got these two very clearly distinct, different types of profile of consumer in Europe. So if you can imagine someone in Europe, low-income household in rented accommodation, potentially have had to sort of pay over and above the market price for rent. They've already gone through their savings simply to keep their head above water in the cost of living crisis of the last

two years. 2004 is going to be very difficult for them. Now compare that to someone who is a professional with decent income. Savings rate in Europe is still very, very high. About 15% is the rate. So basically, you know, 15% of savings as a proportion of their disposable incomes. That's huge compared to, I think it's about 4% or so in the US, Howard.

Correct me if I'm wrong on that one. Yep. But it's bigger. It's bigger in Europe anyway. And if they are lucky enough to be in, say, France and Germany and their mortgages on a massively long fixed rate mortgage, then essentially they are sitting quite pretty

going into 2024. And now it explains some of the odd things we see when it comes to consumer behavior in Europe. There really are these two extremes that have opened up even more. And there's also the difference in the labour markets as well. Like Howard is talking about the productivity gains that we've seen in the US versus Europe, right? What's going on there? I mean, productivity in Europe is definitely a problem. There's been a lot of focus on this in the UK, for example, to do with lack of skills.

in the much needed sectors, incompetent managers, problems with infrastructure, which we also see particularly in Germany, for example, and after the budget saga that we've had in Germany, and the way that they are solving that, which is basically by taking out more spending. So, yeah, there's a lot of stuff going on there, and there are no short-term fixes to this. If you want to solve productivity issue, it's going to take several years of absolutely consistent policy to do so. So a big problem for Europe for some time. This has been something that folks in the U.S. have commented on,

and I think the differences in labor markets matter. Labor market policies matter a lot. And you can say it's inhumane that Europe has a much more robust set of social safety and a much more robust set of sort of practices when it comes to labor retention. One thing the U.S. does well is reallocate, right, across industries, across occupations, across people. So it's easier to let people go. The level of union representation is low.

It's come back a little bit, but still pretty low compared to Europe. And innovation kind of rolls ahead. And if you think about what was happening in, say, the leisure and hospitality space coming out of the pandemic, you can look at the GDP contributions of those industries and those service sector industries actually went up, even though their share of the labor force went down pretty precipitate. That's rising productivity. What happened? Everybody went to delivery. Everybody went to app-based ordering. You didn't need as many servers, et cetera, et cetera, et cetera. Does that account for all of it? No. Is AI percolating back there? Maybe starting to. The number of things that will it continue? That's a big question.

Maybe somewhat. Some people think maybe we've got a little bit of a higher level of potential output creeping into the U.S. outlook for the next little bit. But for now, it's been a boom for the Fed. And I would add actually that in Europe, potentially things are actually a lot, lot better than we would have imagined in, say, spring 2022 after the invasion of Ukraine by Russia. I certainly remember the predictions then of really severe recessions, social unrest and so on. And the European economy has shown a degree of resilience, which I think has surprised lots of commentators, so that if we end up with the type of very shallow recession,

that is being forecast at the moment, I think certainly that a number of policymakers will feel that they have dodged the bullet on that one. Mark, let me toss this out to you. I mean, it seems to be one lesson out of all this, or maybe one fact to think about, is whether or not policymakers on both sides of the Atlantic really have, in a sense,

learn to trim the deep edges off the business cycle. But, I mean, like you say, the outcomes here have been dramatically better than the recession, depression, deep, downturn sort of scenario as we were all contemplating, certainly after the Russian invasion, but going back even further. I mean, since 2020 and the pandemic, it's been kind of a long litany of recessions that didn't happen. Yeah, I think this time around, I think we're really going to have to start talking about debt, if that's the case, right, and rising debt levels,

because, I mean, certainly what we've seen in response to particularly the pandemic, obviously, of the last few years, is a readiness of governments to basically give that kind of fiscal cushion, which means that basically you enjoy yourself against recession. I think it's a very tricky thing politically to start removing that stimulus, which has cushioned economies over the last two or three years. At the moment, we're just kicking the can down the road. But I think that there comes a time when more questions have to be asked on that front. Wow, Mark, Howard was just striking a cheerful note there and I was thinking, you know, maybe economics isn't the dismal science, but you've just brought us back to reality. You've just reminded us we're all on the hawk. Sorry about that. That's all right. That's another year wrapped for major central banks and the hardworking Reuters reporters who cover them.

Thanks to Howard, Mark and the entire economics team that made this episode possible. I hope you're taking a well-earned rest over the holidays. Next year is going to be another roller coaster ride. and we'll be right there with you to cover it. Happy holidays from everyone on the Reuters World News team. The pod is produced by Chris Wall Jasper, Jonah Green, Tara Oaks, David Spencer and myself Carmel Crimmons. Kim Vinal is our regular host. Leila de Kretzer is our executive producer. Engineering and sound design by Josh Summer.

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