Anticipating a Shift in Interest Rates
Next week is set to witness a series of decisions on benchmark interest rates by leading central banks. The Federal Reserve (Fed) is scheduled for a meeting on December 12-13. The European Central Bank (ECB) and the Bank of England are expected to announce their decisions regarding this macroeconomic indicator on December 14. Markets are already in anticipation, not just of changes, but even the expectations of changes in 2024. For instance, regarding the established historical record of the maximum price of gold at $2,111 per ounce (although there was a correction to $2,050). Some attribute the surge to the world's instability, considering gold as a safe haven in such times. Others suggest that markets are betting on a potential policy shift by central banks towards monetary easing. Bitcoin, often dubbed digital gold, is also experiencing a surge, though opinions may differ on this matter. The crucial point is that it appears the era of ultra-expensive money is coming to an end. Consequently, credit card rates, as well as auto and mortgage loans, are expected to decrease.
PHOTO: Gold set a new historical high on December 4 – it has never been so expensive before. However, it soon retraced slightly from the peak. Markets are reacting to the prospect of the end of the era of expensive money. SOURCE: The Gaze, Trading Economics, Getty Images
Gold prices have risen to a historic high, with the previous peak occurring in spring 2022 when the world felt the echoes of Russia's invasion of Ukraine. At that time, all commodities, including gold, experienced fluctuations. Currently, many attribute the increase to the world's growing instability, compounded by the crisis in the Gaza Strip, capturing the attention of both neighboring countries and global players. Some traders also point to the impact of the US dollar's depreciation against a basket of major currencies from last week. According to their view, this is influenced by expectations of a reduction in interest rates by the US Federal Reserve next year.
Central banks' benchmark interest rates are the most potent financial weapon. In the last 12 months, the Federal Reserve systematically increased its rate to curb inflation. Since August of this year, this rate has been consistently held at 5.33% per annum. It is highly probable that the Fed will maintain this rate in the upcoming decision. Additionally, investors and traders are gaining confidence that the Fed will reduce interest rates next year.
In the competition to combat inflation through interest rates, throughout 2022 and the preceding months of 2023, the Fed, ECB, and Bank of England were engaged. There were substantial reasons for this. In June 2022, the annual inflation rate in the US reached 9.1%. In the Eurozone, the maximum inflation was recorded in October 2022 at 10.6%. The British pound also experienced its highest annual inflation in October 2022 at 11.1%.
All of this led to a staggering rise in bills and expenses, demanding extraordinary measures from governments and central banks. As stated, central banks' most powerful tool in the fight against inflation is increasing interest rates. They began raising rates to rejoice in inflation reduction and fear economic slowdowns, as all these phenomena go hand in hand.
PHOTO: The Federal Reserve is concluding its policy of expensive money, but not directly at this moment. SOURCE: The Gaze, Federal Reserve, Getty Images
How They Fought
The battle against rising prices through increased interest rates is a favored instrument of central banks, but the result is not cost-free. If a central bank raises its interest rate, it leads to a slowdown in inflation, but not immediately, with a slight delay. Financial markets are generally quite inert. Side effects of elevated rates are rather unpleasant. The corresponding currency strengthens against others. For instance, when the Fed raised rates, the dollar appreciated against a basket of major currencies. Simultaneously, US exports became less favorable, and imports, conversely, more attractive. This usually leads to a deterioration of the trade balance. High interest rates also contribute to economic cooling. In other words, GDP growth slows down, unemployment rises, and other unpleasant consequences occur.
Therefore, central bank leaders approach this instrument with great caution and use it sparingly. But not this time. Because last year, as noted, inflation in the US almost reached a double-digit mark, and in the Eurozone and the UK, it crossed the threshold of 10% annually. This is terrifying not only in economic terms but also in political consequences.
The US Federal Reserve began raising the rate in the spring of 2022, but at that time, this indicator was at historically low levels, less than half a percent. When inflation in the US reached a peak of 9.1% in July 2022, the Fed had been regularly raising its interest rate for several months, but it only reached 1.63% that month.
Subsequently, inflation in the US began to slow down gradually, but the Fed continued to raise the rate, reaching 5.33% in August 2023. In that month, inflation was 3.7% annually. In other words, inflation was steadily moving towards the target repeatedly announced by Fed Chair Jerome Powell, namely, 2% annually. From September 2023, the Fed stopped raising its interest rate, which remains at 5.33%, with the prospect of waiting a bit longer and starting to decline from 2024, finally.
The most powerful competitor in these races for the Fed is the European Central Bank, which currently holds the main rate at 4.5%. This level was set in September and has not changed since. At the beginning of the campaign to combat inflation, in July 2022, the ECB's main rate was zero. Then there was an increase. When the maximum inflation of 10.6% occurred in October 2022, the ECB still kept the rate at 1.25%. Then it gradually increased until the rate reached 4.5% in September, where it remains for now. And this proved to be enough for inflation in the Eurozone to decrease to 2.9% annually in October, after 4.3% in September.
In the Bank of England, the increase in the interest rate occurred slightly faster. Exactly two years ago, its rate was only 0.1%. Like other central banks, the Bank of England stimulated economic recovery after the crisis caused by COVID-19. And gradually, in small steps, the Bank of England raised the rate to 5.25 at the beginning of August 2023 when inflation was 6.8% annually. After that, inflation in the UK decreased to 4.6% annually, and the interest rate remains unchanged.
PHOTO: Federal Reserve Chair Jerome Powell visited Spelman College on December 1 to participate in a fireside chat with college president Helen Gayle in Atlanta, Georgia. There, he hinted at the possibility of a monetary policy easing. SOURCE: Federal Reserve
What's It All Worth?
All three global central banks are set on reducing inflation to an annual 2%, while maintaining an acceptable level of unemployment. Currently, the unemployment rate is quite low in the US (3.9%), the UK (4.2%), and slightly higher in EU countries (6%).
So, in principle, central banks, at least in the US and the UK, have the ability to pursue a tight monetary policy for further inflation suppression. But it's not all that straightforward. Economic processes are rather inert. The situation suggests that the inflation target may be achieved as early as the first quarter of 2024. However, accumulating issues might lead to economic slowdowns and unemployment due to high rates.
Moreover, high rates significantly irk the average citizen. The cost of mortgage loans and any loans is currently exorbitant. Excessively high credit rates, by the way, indirectly impact prices. So now, central bank heads are treading carefully, but explaining the persistence of elevated rates becomes increasingly challenging.
Of course, no one will preemptively disclose their plans, but the majority of analysts believe that a timeout has been taken in rate hikes, and reductions can be expected next year.
The latest statement from the head of the Federal Reserve (Fed), Jerome Powell, was on December 1, and here's what he said: "The FOMC is strongly committed to bringing inflation down to 2 percent over time, and to keeping policy restrictive until we are confident that inflation is on a path to that objective. It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease. We are prepared to tighten policy further if it becomes appropriate to do so." Perhaps not the most definitive statement, but it was enough for traders and investors to drive gold and bitcoin to record levels on the first day after the weekend. In other words, they are betting on a softer monetary policy, but one will not be right now.