Policy rules point to central banks diverging on rates

A policy rule still points to a slow/shallow rate cut cycle in the US, steady rate cuts in the EA, and that the RBA should hiked a bit more.
Kieran Davies

Coolabah Capital

A simple policy rule points to a slow and shallow easing cycle in the US, gradual rate cuts in the euro area, and risks around the RBA's conscious decision to raise rates by less than other countries in order to lock in the employment gains of the past few years.  

CCI uses a version of the Taylor rule to assess the risks around central bank forecasts for the policy interest rate in the US, euro area, and Australia.

A Taylor rule estimates policy rates based on central bank forecasts for underlying inflation and inflation relative to their respective inflation targets and estimated NAIRUs.

The rule’s estimates are anchored by estimated neutral policy rate in each country, which is where policy rates will end up if central banks successfully return inflation to target and bring demand back into line with supply in each economy.

  • In the US, the rule still suggests that the Fed will be slow to cut rates, starting around Q4 2024/Q1 2025, with fewer cuts in total over the next few years than assumed by Fed policy-makers because the neutral rate looks to be higher than pre-pandemic levels.
  • In the euro area, the ECB started cutting rates this month and the rule suggests the ECB will continue to slowly ease policy as inflation improves, similar to the market-based profile for interest rates that underpins ECB staff forecasts.
  • Australia remains a different story, with the rule still suggesting that the RBA should have raised the cash rate more in the near term.

The divergence in Australia is the result of the RBA board purposefully deciding to raise rates by less than other countries, accepting a slower return to the inflation target in order to retain as much of the gains in employment over recent years as possible.

The risk to this strategy is that interest rates stay high for longer to contain inflation and/or inflation takes longer to sustainably return to the RBA’s 2½% target.  

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modified Taylor rule points to divergence in policy rates across countries
A modified Taylor rule points to divergence in policy rates across countries



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Kieran Davies
Chief Macro Strategist
Coolabah Capital

Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy,...

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