Will rapid interest rate cuts lead to new problems?

- Central banks were right to increase the overnight rate to combat inflation over the past couple of years, argues finance professor George Constantinides

- 'The challenge is we don’t know how much to cut them because we don't know what the neutral real rate is,' says Columbia Business School economist Charles Calomiris

ISTANBUL

While the world's major central banks are expected to cut interest rates in quick succession, experts are divided, as some argue that a rapid decline may harm economies by undermining prior efforts.

This week, the Bank for International Settlements cautioned central banks about swift rate cuts, stating that recessions are likely on the horizon, which should be an additional consideration when deciding the pace and extent of cuts.

On Wednesday, the US Federal Reserve cut its policy rate by 50 basis points, exceeding market expectations of 25 basis points, bringing it to 5%, the lowest level in over a year.

Michael Parkin, an US based economist, told Anadolu that historically, interest rates come down faster than they went up.

Reminding that Canada is lowering the rate since June form 5% to 4.25% gradually during the last three meetings, Parkin said Canada is leading the way and other banks will follow it.

Major banks' decisions

The Fed began increasing its benchmark policy interest rate in March 2022, raising it from 0.25% to a range between 5.25% and 5.5%, a 22-year high, and maintained it during eight monetary policy meetings. It lowered the rate this week for the first time since March 2020.

Since July 2022, the European Central Bank (ECB) has gradually increased its fixed interest rate from 0% to 4.5% until September and kept it unchanged through five meetings. It has lowered the rate twice from June to September to 3.65%.

Beginning its rate-increase cycle earlier, the Bank of England raised its benchmark rate from 0.1% to 5.25% from December 2021 to August 2023, holding it steady over seven meetings. It lowered the rate to 5% in August and maintained it in September.

Earlier, New Zealand began raising its rate in August 2021, increasing it from 0.25% to 5.5% until May 2023, and keeping it steady during eight meetings before lowering it to 5.25% in August.

The Bank of Canada also raised its policy rate from 0.25% to 5% from March 2022 to July 2023 and held it steady during six meetings. It has been lowering the rate over its last three meetings.

From April 2022 to November 2023, the Reserve Bank of Australia raised its cash rate from 0.1% to 4.35%. The rate remained unchanged during the last six meetings.

Despite these hikes by major banks, the Bank of Japan had kept its rate at minus 0.1% since 2015 but decided to raise it to 0.1% in its March meeting and increased it to 0.25% in July, the highest level since end-2008.

Kazuo Ueda, the governor of the Bank of Japan, stated this week that the bank may raise its policy interest rate if underlying inflation trends align with its expectations, signaling a cautious approach to rate increases.

Too much cutting could 'rekindle inflation'

George Constantinides, a finance professor, said central banks correctly raised the overnight rate to combat inflation over the past couple of years.

The Fed was slow to respond but eventually caught up, he said, adding that central banks achieved victory against inflation without triggering a recession.

He said a rapid decline process may cause damages on economies, reminding that the raise was gradual.

Charles Calomiris, an economist from Columbia Business School, remarked that in the US, rate hikes have successfully reduced inflation, making it sensible to now begin cutting rates.

Calomiris does not anticipate damage from the decline process but warns that excessive cuts by the Fed could rekindle inflation.

"The challenge is we don’t know how much to cut them because we don't know what the neutral real rate is," he said, adding:

"If it's 1.5%, we should cut nominal rates to 3.5%, but if it's 1%, we should cut nominal rates to 3%. Too little could lead to a recession. It will be challenging but necessary to cut gradually and learn in real time."