Central banks still need to justify the case for ‘higher for longer’ rates

The writer is head of macro research at BNP Paribas Asset Management

We are on the cusp of a change in central bank tactics. Rates may still rise a little further, but we are probably close to the end of the hiking cycle. The focus is shifting towards keeping rates at these high levels, potentially for an extended period.

If policymakers want the market to embrace the “long hold” narrative, so that financial conditions stay tight and policy continues to exert downward pressure on inflation, they will need to provide a credible explanation as to why rates will stay high for an extended period. Forward guidance without a rationale may not anchor rate expectations for long. That rationale may not be easy to come by.

The policy rate is not a very powerful tool. A standard quarter-point change in rates has a very modest impact on inflation. It should take very little news about inflation to trigger an offsetting change in interest rates. For rates to remain unchanged for the next year or more should therefore require that nothing much happens. It would be a surprise if the volatility of recent months suddenly gives way to an extended period of macro tranquillity.

An extended hold at the peak of the rate cycle is arguably even more unlikely than an extended hold when rates are close to the neutral rate. It took an eye-watering surge in inflation to justify raising rates this far, this fast. Policymakers are trying to drive inflation back to the target but the pace of decline would have to be verging on the glacial to justify keeping rates at this restrictive level for an extended period. However, the month-to-month rate of change of prices has already cooled significantly. And if rates are held steady as inflation expectations start to fall back then real interest rates will rise and the policy stance will paradoxically tighten as inflation falls.   

We know monetary policy is persistent in practice. Reversals are unusual: hikes rarely follow soon after cuts. Policymakers may choose to wait until they are confident that the first cut of the coming easing cycle will not be reversed before they act. But that means waiting until there is enough news to justify multiple cuts before delivering the first. Investors may therefore be comfortable with the idea that the hold could survive for some time, but that when the hold ends it will be followed by a sequence of cuts.

Nor should we think about an extended hold as a “higher for longer” mirror image of the strategy that central banks pursued over the past decade. Rates were on the floor back then despite the anaemic inflation outlook because the perceived costs of stimulating the economy further with negative rates or more asset purchases were thought to exceed the benefits. Rates were lower for longer because policy was at an effective lower bound. The same logic does not apply here. There is no effective upper bound.

An extended hold starts to look more plausible if central banks have underdelivered and failed to complete the hiking cycle. It should take a lot of downside news on inflation to convince investors that cuts are warranted if they believe that the policy rate has deliberately been set too low today. But now the hold is under pressure on the other side. It should not take much upside news to trigger expectations of multiple hikes if rates are set too low today.

Conversely, an extended hold looks less plausible if central banks have over-delivered and rates have been set above the level warranted by the current inflation outlook. If investors believe rates are too high to begin with, then it should take very little news that inflation is falling, or unemployment is rising indeed, to trigger expectations of multiple cuts. 

On balance, it seems more likely that policymakers have over- rather than underdelivered. Many if not most policymakers appear to have been in risk-management mode. Rates have been raised above what looks necessary given the most likely path of inflation. These “insurance hikes” provide some protection against the risk that inflation proves highly persistent — or, if you prefer, that the central banks’ models are wrong. When that risk recedes, policy should adjust. “Insurance hikes” should then be reversed, not held for an extended period.

If central banks do pivot from hike to hold then they will need to give clear and credible communication if they want to anchor rate expectations on an extended hold. Above all, central banks need a coherent narrative that links the old plan with the new plan. It is hard to explain how you are in risk management mode one day and committed to an extended hold the next.