Central bank easing all depends on inflation

With fears related to the US banking crisis subsiding, inflationary developments should now be the main factor deciding how fast central banks worldwide lower their interest rates.

One of the most important developments influencing central banks in most countries to start easing monetary policy is the significant drop in headline inflation. Falling energy prices are now dragging down headline inflation worldwide. In fact, the figure has come down even faster in countries like the US, where high energy prices are less of a problem.

Meanwhile, headline inflation in many Asian economies seems to be quite under control, given that the rise in inflation over the past year or so has been less severe to begin with. Given these developments, it is almost certain that hiking cycles by central banks are coming to an end.

However, apart from headline inflation, core inflation is another important key in determining the start of the easing cycles. Central banks have been raising interest rates to slow down demand, but it is uncertain whether weaker demand will be able to bring inflation down, as wage pressures persist in most countries.

Unless these pressures subside, costs of production will remain high despite falling input prices, causing overall prices of goods and services to stay elevated.

Although declining headline inflation and inflation expectations will likely help reduce wage growth, the labour market is still very tight in many advanced economies. For instance, the unemployment rate in the US touched a 50-year low of 3.4% in April, while the same figure in the EU went down to 6.5% in March, marking the lowest on record.

While wage growth is expected to slow eventually, the pace should differ in different countries. For an illustration, the figure should fall quite slowly in the euro zone due to ongoing tightness in the labour market. Another feature of European economies is that indexation allows high rates of inflation to directly push wages up. Similarly, the UK is facing a wage-price spiral where high price levels cause workers to demand more and bigger pay rises.

Meanwhile, pay gains in the US picked up in April after having cooled down a month before. Although this development signals that labour market tightness is still an issue in the US, many experts suggest that the increase in April could be a one-time jump rather than a reversal of the cooling trend. This is because hourly earnings can jump from month to month. Given these situations, the start of easing cycles should differ for each country too.

That said, most emerging market economies should be the ones to see interest rates falling first since they had short and speedy hiking cycles, relatively lower inflation levels compared to many advanced economies, and less dependence on US monetary policy decisions.

The next group to lower interest rates should be econmies that are prone to financial instability given more tightening, like the US, followed by those that are still struggling with high price levels and tight labour markets.

According to Capital Economics, most emerging market economies are likely to begin lowering interest rates in the middle of this year, while the US should follow in early 2024. Meanwhile, the euro zone and the UK are expected to start easing monetary policy in late 2024.