New Inflation Warning: Prepare for High Interest Rates

The International Monetary Fund has warned that stubborn inflation could maintain higher interest rates for longer than anticipated, increasing fiscal and financial risks globally.

Persistently high prices for services, including haircuts, hotels and restaurants, as well as escalating trade tensions are sustaining inflation. This raises the possibility that interest rates will remain high for a while yet, the IMF warned in its latest World Economic Outlook.

The warning emphasises that the global economy is not yet in the clear when it comes to inflation, which explains why central banks are cautious about cutting interest rates. High borrowing costs continue to pressure household and business finances.

The previous week, Federal Reserve Chair Jerome Powell said that U.S. central bank officials in the needed “greater confidence that inflation is moving sustainably” toward their 2% target before considering the first interest rate cut.

Last month, the Bank of England opted not to cut rates even though UK inflation slowed to the central bank’s 2% target in May. However, inflation in the services sector was higher than expected.

The Bank of England emphasised that “monetary policy needs to be restrictive for an extended period of time until the risk of inflation becoming embedded above the 2% target dissipates.”

In its report, the IMF stated that it still expects major central banks to reduce borrowing costs in the second half of the year. Chief economist Pierre-Olivier Gourinchas said that the IMF anticipates one rate cut by the Fed before the year ends.

The IMF expects global inflation to slow to 5.9% this year, down from 6.7% last year, consistent with its forecast in April.

The agency blamed the slow progress in reducing overall inflation on persistent price inflation in the services sector, partly driven by higher wages.

“Energy and food price inflation are now almost back to pre-pandemic levels in many countries, while overall inflation is not,” Gourinchas said. “Rising services prices and wages may keep overall inflation higher than desired,” posing a “significant risk” to economic growth, he added.

Inflation threaten living standards

The IMF stressed that escalating trade tensions “could further raise near-term risks to inflation by increasing the cost of imported goods.”

Trade tariffs could lead to damaging cross‐border spillovers, and trigger retaliation, creating a costly race to the bottom.

In countries where upside risks to inflation have materialised, the IMF advises that central banks should avoid easing too early and remain open to further tightening if necessary.

The IMF suggested that where data encourages a durable return to inflation targets, central banks should reduce rates gradually.

Recently, the US and the European Union have raised tariffs on electric cars made in China, driven by concerns that local jobs and strategic industries could be threatened by cheap Chinese imports. Additionally, the US has increased tariffs on various other products from China, including steel, batteries, semiconductors and critical minerals.

Gourinchas said the “surge in unilateral measures,” including tariffs, was a “key concern” for the IMF.

“If anything, it will distort trade and resource allocation, spur retaliation, weaken growth, diminish living standards and make it harder to coordinate policies that address global challenges, such as the climate transition,” he added.

The IMF expects the global economy to grow by 3.2% this year, as it forecast in April. However, it has downgraded its forecast for US growth to 2.6%,  0.1 percentage points lower than previously anticipated.

The economy of the 20 countries using the euro is expected to expand by a “modest” 0.9%, an increase of 0.1 percentage points higher than predicted in April.

The IMF also revised its 2024 growth forecasts for India and China, which it now expects to expand by 7% and 5% respectively, compared to the previous forecasts of 6.8% and 4.6% in April. The expected growth in the two countries would account for 50% of global expansion.

“Asia’s emerging market economies remain the main engine for the global economy,” Gourinchas said.

Global Economic Growth and Inflation Outlook

The IMF’s outlook for global growth remained the same as its last report in April, projecting a 3.2% growth in 2024 and 3.3% in 2025.

Growth in the US was revised down slightly by 0.1% for this year to 2.6%. Growth is expected to slow to 1.9% in 2025 as the job market cools, consumer spending moderates, and fiscal policy begins to tighten gradually.

In the eurozone, the economic slowdown seems to have bottomed out. The IMF raised its forecast for the euro area this year by 0.1% to 0.9%, driven by stronger momentum in services during the first half of the year. Growth in the eurozone is projected to rise to 1.5% in 2025.

China is expected to drive growth in emerging markets this year, with the IMF forecasting growth of 5%. This growth is driven by a rebound in consumer spending and strong exports observed in the first quarter.

However, looking ahead to next year, China’s growth is expected to slow to 4.5%, with further deceleration over the medium term to 3.3% by 2029. This is mainly due to headwinds from aging and slowing productivity growth.

Markets expect Fed rate cuts in September

Investors are increasingly confident that the Federal Reserve will reduce interest rates by the end of its September meeting.

According to the CME FedWatch Tool, markets were pricing in a 100% probability of an interest rate cut in September, up from a 70% a month earlier.

The increased confidence follows a stronger-than-expected June inflation report and indications of continued cooling in the labour market. Economists and investors interpret the data to mean the Fed will begin cutting interest rates soon as inflation falls closer to the Fed’s target of 2%.

Fed Chair Jerome Powell said that recent data has “somewhat” boosted the central bank’s confidence that inflation is approaching its target. However, Powell declined to detail how this affects the Fed’s schedule for potential rate cuts.

With recent improvements in inflation data alongside signs of a slowing labour market, some on Wall Street are urging the Fed to begin cutting interest rates before there are negative effects on the US economy’s labour market.

In a recent research note, Jan Hatzius, the chief economist at Goldman Sachs, argued there’s “a solid rationale” for the Fed to start cutting rates at its next meeting on July 31.

“First, if the case for a cut is clear, why wait another seven weeks before delivering it,” Hatzius wrote. “Second, monthly inflation is volatile and there is always a risk of a temporary reacceleration, which could make a September cut awkward to explain. Starting in July would sidestep that risk.”

Hatzius also noted that by cutting rates in July, the Fed could avoid further speculation regarding a political motive behind its policy decisions, despite pledging its independence from the upcoming election. With two weeks remaining until the Fed’s next meeting, investors are pricing in a mere 7% probability of a rate cut in July, according to the CME FedWatch Tool.

Whether July is a possibility or not, investors now feel confident that interest rates will trend lower in the near future. The confidence that cuts are coming soon contributed to a broader rally in the stock market.

The most-favoured areas of the market over the past year have shown weaker performance recently as investors shift focus into sectors outside of tech.

When will interest rates go down?

The Federal Reserve has decided to maintain interest rates steady following its meeting on June 11 and 12, 2024. The federal funds target rate has stayed at 5.25% to 5.5% since July 2023.

To tackle inflation, the Fed raised interest rates 11 times from March 2022 to July 2023. While inflation has eased, the Fed has indicated it wants more positive data before considering any further rate adjustments.

In March 2024, the central bank predicted three quarter-point cuts by year end. However, as time goes on, the certainty of these cuts has become less.

The Federal Open Market Committee (FOMC), chaired by Jerome Powell, meets eight times annually to discuss whether to adjust the federal funds rate, a benchmark that governs overnight lending between commercial banks. The group of 12 considers inflation, employment and the rate of borrowing, among other economic factors.

In 2024, the FOMC has met four times so far, but declined to change rates. The upcoming meetings this year are:July 30 and July 31, 2024, Sept. 17 and Sept. 18, 2024, Nov. 6 and Nov. 7, 2024, and Dec. 17 and Dec. 18, 2024

Amy Hubble, principal investment advisor at Radix Financial, told CNBC Select she doesn’t anticipate a rate hike in July.

“That doesn’t mean that the Fed is doing nothing, though,” Hubble said. “They’re doing their job — while we don’t have any weaknesses in the job market, which is the Fed’s most important objective, you still see inflation above 3%. That’s higher than we want. We have started to see that come down, but we’ll see how the summer goes.”

What to expect when rates go down?

The Federal Reserve requires banks and other depository institutions to maintain a reserve of 10% of their deposits. To stay near that threshold without falling below it, banks loan each other money back and forth.

The FOMC sets the interest rate which banks can charge each other, known as the federal funds rate. Banks then adjust the interest rates that they charge consumers.

Since July 2023, the federal fund rate has ranged from 5.25% to 5.50%, the highest since January 2001, when it rocketed to 6.00% following the dot-com bubble burst.

Amy Hubble explained, “When the Fed funds rate goes down, it will affect everything a little differently and in different magnitudes. CDs and other shorter-term cash vehicles, like money markets and bank savings rates, will see the rates drop almost immediately.”

They won’t be huge cuts, she added, but slight decreases in 0.25% increments over several years.

Changes to mortgage rates are more complex because creditworthiness and loan terms play a more significant role in determining rates.

“These rates may not necessarily move exactly in tandem with a reduction in the federal funds rate,” Hubble said. “But it’s still fair to assume that a lower fund rate will also mean a lower mortgage rate.

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