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The Opening Gambit for Central Banks: Unravelling the 'Who Cuts First?'

Sukhdeep Dhillon • 5/2/2024

Central banks are widely considered to have concluded their cycles of monetary tightening. Now, however, speculation surrounds which central bank will initiate rate cuts, as well as when and what the degree of those cuts will resemble when.

In this article, we discuss the UK and euro area inflation and subsequent projected monetary policy paths.

Recent sentiment surrounding other central bank moves is shifting. A month ago, the common consensus was a coordinated easing in June, but since the recent U.S. inflation data release, this has likely pushed the first Federal (Reserve) Open Market Committee cut back to Q4 2024, if not later. Markets are now pricing in one cut in 2024, with a slight edge favouring November. U.S. data have shown strong economic momentum alongside stubborn inflation readings lately. As a result, the Fed is not expected to lead the way relative to the ECB and BoE with initiating cuts, as is typically the case with global monetary policy trends. The transition away from the Fed taking the lead to the ECB and BoE making a move is somewhat unprecedented. It is also uncommon for the ECB to be the first. The reason is that the anticipated inflation trajectories for the euro area, UK, and U.S. have been more coordinated in their underlying trends. This alignment enabled central banks to seemingly heed signals from the FOMC and act in a more synchronised manner.

ECB Leading the Way

At the latest meeting (April), the ECB adhered to expectations by maintaining borrowing costs. However, it hinted at the possibility of cutting interest rates soon, despite the recent change in the expected trajectory of the federal funds rate in the U.S.

Much of the ECB’s ability to consider upcoming rate cuts links to the region’s relatively more muted economic growth and inflation conditions relative to the U.S. Both the euro area and the UK have endured prolonged economic stagnation, with five consecutive quarters in the former and seven in the latter. Consumer spending in the euro area and the UK is non-existent (2023 Q4: UK -0.1%, euro area 0%), a condition which differs considerably from the U.S., whose consumer spending and household metrics maintain remarkable resilience. Meanwhile, a weaker consumer sector in the euro area and UK has also been accompanied by sluggish investment, a softening labour market, and a slowdown in wage growth, collectively signalling downward pressure on prices.

In stark contrast to the U.S. and the conditions facing the FOMC, the most recent estimates for inflation figures for the euro area were in line with expectations, with the latest inflation estimate for April at 2.4%, whereas inflation in the UK is trending in the right direction, though still above target at 3.2% (March). It is worth noting that the ECB and the BoE are tasked solely with maintaining price stability, directing their efforts towards controlling headline inflation. In contrast, the Fed operates under a dual mandate, addressing both inflation and unemployment targets. Nonetheless, for the UK and the euro area both core and headline inflation have consistently been trending in the right direction.

On the other hand, economic growth in the U.S. has exceeded expectations, persisting above trend, while the labour market has remained tight and inflation has topped forecasts. This heightens the risk of sustained inflationary pressures.

‘Data-dependent, not Fed-dependent’

During the ECB’s press conference, Christine Lagarde recognised the importance of U.S. economic developments, but she also emphasised that the euro area's conditions were different.

Though the projected (policy) interest rate paths for the euro area, UK, and U.S. have closely resembled each other over the past month, disparities in macroeconomic fundamentals and inflation dynamics are now initiating a divergence in those paths. Despite the U.S. leading the run-up to peak inflation relative to the euro area and the UK by four months, the former regions have witnessed a swifter contraction in inflation trends.

Several differences in regional drivers of inflation can help to underscore the divergent deflationary paths. Core1 inflation was less of a driver for overall inflation in the euro area while it was more widespread for the UK and U.S. For further insights into regional inflation disparities, please refer to our previous report.

In recent times, U.S. inflation has been notably influenced by sustained rises in housing costs.

Rent inflation has been more pronounced in the U.S. for two main reasons:

  1. Owners' Equivalent Rent (OER) is captured/measured in the U.S. official numbers and,
  2. U.S. population and labor supply growth have been stronger, resulting in stronger demand for housing.

Delving into the first factor contributing to elevated Rent inflation in the U.S. and contrasting that with the UK: the UK housing market has not faced as much pressure given different measurements and trends. Firstly, the Harmonized Index of Consumer Prices (HICP) and the UK CPI exclude owner occupiers’ housing costs, resulting in a lower weighting for rent in the UK and euro area compared to the U.S., where housing costs comprise 36% of the CPI and 16% of the Personal Consumption Expenditures (PCE) Index.2 However, according to the IMF, adding owner-occupied housing costs to the HICP wouldn't significantly alter the euro area's latest inflation figures as housing cost inflation closely mirrors overall inflation in the euro area. According to the IMF's analysis

While the measured inflationary impact of housing is expected to ease in the U.S., the Fed's primary concern currently lies in the stagnation of progress made on measures over 3- and 6-month periods, particularly for the supercore index, which excludes housing, food, and energy. Medical services inflation, which carries greater weight in the PCE than CPI (the former of which is considered the Fed’s preferred inflationary measure), is also expected to be strong in the near-term. Moreover, the recent surge in global oil prices is expected to contribute to inflationary pressures in the upcoming months.


PCE AND CPI Inflation: What's the Difference?

The U.S. produces two consumer price indices measuring inflation while most other countries typically have one measure (CPI). The CPI is produced by the U.S. Bureau of Labor Statistics and the PCE by the U.S. Bureau of Economic Analysis.

Each index is constructed differently. For example, the relative weights assigned to each of the CPI and PCE categories are based on different methodologies; weights in the CPI are fixed for a given year, whereas weights vary each month in the PCE. One can think of the CPI as measuring out-of-pocket expenditures by urban consumers, and of the PCE as measuring expenditures purchased by or on behalf of all consumers - even if such purchases are made by third parties like a non-profit, insurance company, the government, etc.

The FOMC target core PCE inflation, but closely monitors all measures of inflation.


The second reason for higher rent inflation in the U.S. versus the euro area and UK lies in the supply-side dynamics, namely differences in population, labour supply growth and other supply-side dynamics:

  • Unemployment: The U.S. labour market’s strength continues to exceed expectations with the unemployment rate currently at 3.8%, in contrast, the UK unemployment rate is currently 4.2% and the euro area is 6.5% in Feb. As long as the U.S. labour market remains as tight as it is, it's probable that overall nominal wage growth will continue.
  • Productivity4 : Despite productivity growth slowing across most countries since the Global Financial Crisis, the UK and the euro area still trail behind the U.S. in terms of productivity gains. Productivity in the euro area declined by 1.2% (YOY), and the UK experienced a decrease of 0.3%, while U.S. productivity rose by 2.6% in Q4. If the UK and euro area’s productivity continues to fall behind the U.S., GDP growth will ultimately be lower.
  • Potential GDP/ output gap: The size of the labor force and the rate of productivity growth (measured as output per hour of work) determine potential GDP. The euro area's potential GDP growth rate is estimated at 1-1.5% annually, while the UK's ranges from 1-1.3%. In contrast, the U.S. has a potential growth rate of 1.5% to 2.0%, indicating its capacity to accommodate further growth in domestic demand without facing inflationary pressures. Given the U.S. experiencing higher potential GDP growth, there could be a surge in housing demand, thereby keeping housing rent inflation above historical levels.

Is a June cut a done deal?

Nothing is a done deal. But, for the ECB, we think they will proceed with a 25-basis-point (bp) cut, followed by the BoE in August. By the June meeting, policymakers will have access to complete Q1 wage growth data, which has been a focal point for all central banks.

How do we think this data will evolve to set up a June cut?

Wage growth in the UK stood at 4.8% in February, remaining above the BoE’s comfort threshold of approximately 3%. However, job vacancies have stabilised, suggesting a slowdown in the labour market. It's important to note that the April data will incorporate the 10% increase in the National Living Wage External Link. Aside from this, we anticipate a moderation in wage growth in the UK moving forward. For the euro area negotiated wages External Link5 have decreased from 4.7% to 4.5% in Q4 2023. While this decline isn't substantial enough to instill full confidence in the ECB to lower interest rates, it does align with our expectation of a gradual slowdown in wage growth throughout the year which is what the ECB would like to see.

Implications for Commercial Real Estate

The CRE sector has been eagerly anticipating interest rate cuts, with the expectation that reduced rates will boost velocity in the market and property values. While the significance of interest rates to the CRE sector cannot be overstated, given their influence on financing costs, the implications for CRE can be summarised as follows:

  • Prime time: historically, periods of market dislocation and pause arise as excellent vintage years for investment, as they offer relatively less competition and potentially more appealing entry points. This window of opportunity, between now and the oncoming central bank cuts, arises as a similar attractive entry-point (ahead of the full-swing return to liquidity once cuts ensue). This also presents as a relatively attractive sell-side time to capitalise and profit from the bounce back and inflection in real estate valuations. Some evidence suggests yields in certain markets have already stabilised, particularly markets that have witnessed swifter yield adjustments offering attractive entry points.

  • Initiating a sequence of events: a cut in interest rates will set off a series of events, lowering real estate debt costs from current levels, placing downward pressure on yields and subsequent upward pressure on pricing. The speed at which a policy rate cuts filter through can and will vary significantly by lender, deal profile and asset class. The transmission to bank lending rates follows a more nuanced trajectory. Commercial banks adapt their rates in response to base rate shifts over several weeks to months as they are also influenced by market conditions and internal funding considerations. The adjustment in commercial bank rates can also take place before an official cut if it is widely expected and signposted. More importantly, the price expectation gap between buyers and sellers will narrow as they gradually acclimate to the new pricing levels.

  • The era of cheap money is over: as we expect a gradual and less pronounced easing cycle interest rates are expected to stabilise at higher levels not going to the levels seen after the GFC when rates fell close to zero for the UK and negative for the euro area, prompting investors to incorporate the comparatively higher borrowing costs into their financial calculations. As observed in past cycles, investors are likely to adjust to this new interest rate landscape, rendering the cost of debt less significant comparatively. As the mix of active lenders changes due to tighter bank liquidity, attention may shift from debt cost to its availability. While some traditional sources like banks limit debt availability, private credit remains eager, albeit at a higher cost. Despite potential rate cuts and marginal improvements in rates and spreads, debt costs will likely continue to hinder liquidity until pricing adjusts fully. More investors’ focus is likely to turn to delivering rental growth and asset management to sustain out-performance.

1 Core inflation is the underlying rate of inflation; it does not include food or energy prices, which are volatile.
2 PCE is one of the main measures of inflation and consumer expenditure within the U.S., tracking the prices of a basket of goods and services
3 ECB Economic Bulletin: Owner-occupied housing and inflation measurement External Link
4 Output per hour worked
5 Denotes the weighted mean of the yearly growth rates of collectively agreed wages, it is used to identify potential indications of wage pressures by the ECB.

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