Expert explains why central banks are cutting rates By Investing.com

In the current economic climate, central banks around the world are contemplating or already implementing interest rate cuts. This decision is not without controversy, as some critics argue that such moves might be ineffective in preventing a recession or even exacerbating economic troubles.

However, as per economists from TS Lombard, there are compelling reasons why rate cuts could indeed be beneficial and why the central banks’ approach should be seen in a more favorable light.

The notion that rate hikes had no discernible impact on the economy is a misconception. Interest rate increases affected interest-sensitive sectors almost immediately. For instance, housing demand plummeted, real estate investments stalled, and durable goods demand slowed significantly.

The global construction sector, in particular, faced challenges, although it was somewhat buffered by projects initiated during the COVID-19 pandemic when supply constraints were prevalent.

This initial impact of rate hikes was noticeable through “flow” effects—where immediate changes in investment and credit demand were observed. In contrast, the “stock” effects, which pertain to the impact on debtor disposable incomes, evolved more slowly.

The muted response in this area during the latest tightening cycle can be attributed to the fact that both households and corporates had restructured their debts, thus preventing significant financial distress despite higher debt servicing costs.
Rate cuts have the potential to stimulate economic activity rapidly. As per TS Lombard, rate-sensitive demand should increase promptly, leading to a rebound in housing demand and a revival in construction activity.

Furthermore, lower rates could reinvigorate the durable goods sector, providing a boost to global manufacturing. More critically, a monetary policy pivot at this juncture could prevent a further tightening of conditions due to the stock effects of previous rate hikes.

Without immediate rate cuts, monetary policy is set to become even tighter as the lingering effects of previous rate hikes continue to build up. This scenario could potentially squeeze economic activity further, making the case for preemptive rate cuts stronger.

The influence of rate cuts on asset prices hinges largely on the context in which they are implemented. Preemptive rate cuts, designed to ward off potential economic downturns, often have a positive impact on risk assets. These cuts signal a proactive stance from central banks, suggesting economic stability is a priority. Consequently, investor sentiment tends to improve, driving up asset prices.

Conversely, reactive rate cuts, introduced in response to existing economic challenges, can have a more complex effect. While they aim to stimulate the economy, they may also indicate a deteriorating economic landscape, potentially dampening investor confidence and asset prices.

Early in the year, the prevailing sentiment was that central banks were adopting a preemptive approach, which buoyed risk assets. However, the subsequent uptick in inflation introduced uncertainty.

Despite concerns, TS Lombard flags that the labor markets have not yet shown signs of a severe downturn. Employment figures remain relatively stable, which suggests that the central banks may not be behind the curve just yet.

Historically, central banks like the Federal Reserve, under Alan Greenspan in 1995, waited for more concrete signs of economic trouble before adjusting policy. In this context, while a soft landing might be challenging, it is difficult to foresee a scenario worse than a mild recession based on current economic fundamentals.