Why not to get too excited about a September rate cut

New MIT Sloan research on patterns in interest rate cycles shows that the transition from hiking to cutting rates does not necessarily imply that interest rates will fall back to the low levels from before the pandemic.

CAMBRIDGE, Mass., September 16, 2024 – The unprecedented 2020-2024 interest rate cycle marked the fastest pivot from an active easing to tightening by policymakers in advanced economies since the 1970s. What followed was the most globally synchronized, aggressive rate tightening in the last 55 years — and it was also the longest period policymakers held rates at their peaks.

Even if the Federal Reserve pivots to cutting interest rates, rates may not fall to levels typical of the last 15 years during this rate cycle. This would leave consumers and businesses in a world of higher rates, sending a ripple effect throughout the U.S. economy, and prompting more difficult tradeoffs, suggests a new paper “Rate Cycles” by MIT Sloan School of Management professor of global economics and management Kristin Forbes and colleagues.

Presented at the European Central Bank’s (ECB) annual Forum on Central Banking in Sintra, Portugal, in July, the findings have implications for policymakers and investors alike. A week before the Federal Reserve’s latest monetary policy meeting, investors expect policymakers to cut interest rates for the first time in four years, lowering them from their 23-year high as inflation eases. Based on the Fed’s latest projections, some anticipate that rates will drift lower from there, eventually settling in at around 2.5% to 3%. But rates may also not fall that much.

“It’s not clear that rates need to fall to pre-2008 levels, even if the market is expecting them to,” Forbes said. “If so, we’re going to have to adjust to a world of higher interest rates, and it may be painful. There could be a big reckoning.”

Along with Jongrim Ha and Ayhan Kose from the World Bank, Forbes analyzed cycles in interest rates in 24 advanced economies from 1970 to 2024, looking at how rate cycles have evolved over time. The paper and its findings are novel because, while many researchers have dissected business cycles, Forbes believes they are the first to apply an in-depth business cycle analysis to interest rate cycles.

The researchers found that after the recent unprecedented swings in economic activity and aggressive central bank responses, growth and labor markets now seem to be stabilizing despite interest rates remaining at high levels not seen since before the 2008 financial crisis.

If rates do remain high, homeowners looking to sell, but holding out for cheaper rates, may find it more difficult to relocate. Companies that financed debt when interest rates were lower would pay more as they refinance. The federal government, for its part, is already paying substantially more interest on its debt, and it’s an expense that will only grow as deficits show no signs of abating. To compensate, taxes might go up, or federal spending fall — or both.

At the same time, rates at higher levels can provide some benefits to the economy if it makes consumers and businesses borrow more efficiently. People may be more cautious to take on debt, only borrowing if they’re confident about the return on investment. Younger Americans might have a harder time getting student loans or buying a home, but older ones with savings would benefit from higher rates. Overall, Americans might save more.

The researchers also discovered that during the 2020-2024 interest rate cycle, the impact of global shocks was not only bigger than home-grown factors, but had their largest impact on rates since the 1970s. This makes it even more challenging for central bankers who focus on stabilizing prices at home. Part of the shocks were well-documented global supply shocks, including supply chain disruptions around the pandemic and a spike in food and energy prices after Russia invaded Ukraine in 2022.

Forbes and her colleagues found that global demand shocks were also significant, yet they were largely underappreciated. Consumers who had saved their money and were ready to spend found that supply was lagging behind. In the coming years, policymakers will increasingly find themselves responding to global shocks, and distinguishing between supply and demand shocks will be critical, Forbes said.

“Policymakers will need to go one step further and not assume that they’re dealing with a global supply shock just because it originates outside their borders,” she said. “It could very well be a global demand shock, and there’s a very different response for each.”

With supply shocks, policymakers usually don’t need to raise interest rates as much in response, according to the researchers. On the other hand, they should respond more forcefully when they encounter demand-driven shocks. Teasing apart global and domestic forces as the drivers of shocks in individual economies is crucial, too, and the researchers discovered that supply shocks play a much greater role in the Euro area than they do in the United States.

Going forward, central bankers need to fully commit themselves to looking at multiple models as they set interest rates. “They need to look at a range of prices and be open to a variety of explanations and risks as they conduct monetary policy,” Forbes said, especially as she sees the current cycle as a cautionary tale. “Just because central banks’ strategy of starting late and then acting aggressively worked this time, it does not necessarily mean it will work in the future.”

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