An expert explains why central banks are cutting rates By Investing.com

In the current economic climate, central banks around the world are considering or are already implementing interest rate cuts. This decision is not without controversy, as some critics argue that such measures could be ineffective in preventing a recession or even exacerbate economic problems.

However, according to economists at TS Lombard, there are compelling reasons why rate cuts could actually be beneficial and why central banks' approach should be viewed in a more favourable light.

The idea that rate hikes had no discernible impact on the economy is a mistake. Interest rate increases hit interest rate-sensitive sectors almost immediately. For example, housing demand plummeted, real estate investment stagnated, and demand for durable goods slowed significantly.

The global construction sector in particular faced challenges, although somewhat cushioned by projects initiated during the COVID-19 pandemic when supply constraints prevailed.

This initial impact of rate hikes was felt through “flow” effects, where immediate changes in investment and credit demand were observed. In contrast, “stock” effects, which refer to the impact on borrowers' disposable income, evolved more slowly.

The weak response in this area during the last adjustment cycle can be attributed to the fact that both households and firms had restructured their debts, thus avoiding significant financial difficulties despite higher debt service costs.
Rate cuts have the potential to rapidly stimulate economic activity. According to TS Lombard, rate-sensitive demand should increase rapidly, leading to a rebound in housing demand and a revival of construction activity.

Moreover, lowering rates could revive the durable goods sector, giving a boost to global manufacturing. More importantly, a change in monetary policy at this time could prevent further tightening of conditions due to the effects of previous rate hikes.

Without immediate rate cuts, monetary policy will become even more restrictive as the lingering effects of previous rate hikes continue to build. This scenario could potentially further dampen economic activity, strengthening the case for preemptive rate cuts.

The influence of rate cuts on asset prices depends largely on the context in which they are implemented. Preemptive rate cuts, designed to avoid potential economic downturns, typically have a positive impact on risk assets. These cuts signal a proactive stance by central banks, suggesting that economic stability is a priority. As a result, investor confidence tends to improve, driving up asset prices.

By contrast, reactive rate cuts, introduced in response to existing economic challenges, can have a more complex effect. While they are intended to stimulate the economy, they can also signal a deterioration in the economic outlook, which could weaken investor confidence and asset prices.

At the start of the year, the prevailing sentiment was that central banks were taking a precautionary approach, which boosted risk assets. However, the subsequent surge in inflation introduced uncertainty.

Despite concerns, TS Lombard warns that labour markets have yet to show signs of a serious slowdown. Employment figures remain relatively stable, suggesting that central banks may not have fallen behind yet.

Historically, central banks, such as the Federal Reserve under Alan Greenspan in 1995, waited for more concrete signs of economic trouble before adjusting policy. In this environment, while a soft landing may be difficult, it is difficult to foresee a scenario worse than a mild recession based on current economic fundamentals.