Key central banks, including the U.S. Federal Reserve, European Central Bank (ECB), and Bank of England, are now aligned in slashing interest rates, sparking a real-time experiment on how much the global financial environment has evolved since the pandemic. A major question looms: Will the easing cycle be short-lived due to higher underlying rates?
The Federal Reserve’s recent larger-than-expected half-point rate cut follows similar moves by other major central banks, which some analysts believe helped clear the way for China’s largest stimulus package since the pandemic without destabilizing its currency. However, the long-term trajectory of these rate cuts remains uncertain, as central banks grapple with whether the rates required to maintain stable inflation and growth have shifted higher compared to the ultra-low levels seen before the pandemic.
Policymakers in Washington, Frankfurt, and London are cautious about pinpointing the so-called “neutral” rate—the level at which interest rates neither stimulate nor restrict economic growth. Determining this rate will likely involve a combination of intuition and economic data rather than precise models, making it a difficult balancing act. Nonetheless, there is broad consensus that this neutral rate is higher than pre-pandemic levels, which may temper the pace and extent of further rate cuts.
Fed Chair Jerome Powell expressed skepticism about a return to the near-zero rates that dominated the pre-pandemic era. “That world is gone for good,” Powell remarked, emphasizing that the neutral rate is likely “significantly higher” than before. He added, “We only know it by its works,” referring to the need for inflation to stabilize at the Fed’s 2% target, alongside steady wage growth, unemployment, and economic activity.
The Bank of Japan remains the lone outlier, having tightened policy after achieving its inflation goals. Meanwhile, the Fed’s projections indicate a median stopping point for rate cuts of around 2.9% by 2026, though forecasts vary from 2.4% to as high as 3.9%.
Fed Governor Michelle Bowman contends that the neutral rate is “much higher than it was,” suggesting the Fed might be closer to its theoretical floor than many expect. This implies that the global rate-cutting cycle could be more cautious and short-lived than initially anticipated, as central banks navigate an altered post-pandemic economic landscape.
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