Chief Economist's Corner: The difficult interest rate journey

“The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”

That was the message from Jerome Powell, the chairman of the US Federal Reserve, at the most important meeting of the year for leading monetary policy decision-makers, namely the Jackson Hole symposium. As always, it took place at the end of August and has increasingly become THE PLACE where the major central banks air their thoughts to the outside world about possible new developments in monetary policy.

At this year's meeting, Powell announced that the Fed was ready to begin a cycle of rate cuts, following in the wake of the ECB, which had already cut rates in June. That is in itself a bit of a novelty, since the Fed is usually the first to react when it comes to changing interest rates.

As is well known, the Fed chose to cut rates from 5.5% to 5% at its meeting in September and again by 0.25% point at its meeting just after the presidential election, while the ECB two weeks ago cut rates from 4% to now 3.25%. And the question is not whether interest rates will be cut further, but by how much and how quickly. Both the Fed and ECB are widely expected to cut interest rates again by 0.25 in December.

But why are central banks so busy at the moment? Even though inflation is getting under control, core inflation, which excludes energy and food prices, is still well above the target of 2% on both sides of the Atlantic. In addition, labour markets are strong, creating the basis for historically high wage increases, which may be passed on to consumer prices.

One answer could be that the high interest rates make it difficult to finance the sharply rising costs for defence, the green transition and servicing of public debt, which have sky-rocketed in many countries in the wake of the pandemic unless interest rates are cut quickly. And even though the central banks are independent, it cannot be ruled out that they are considering this.

Another answer could be that lower interest rates are needed and to pull economic growth in Europe out of prolonged stagnation. This is not the case to the same extent in the US where the economy remains strong, but it is important to keep in mind that monetary policy also works in the US with a long lag. The tighter financial conditions have therefore not necessarily yet fully impacted the economies, even though it has been a long time since interest rates were last raised. In addition, monetary policy tightening dampens activity as long as the policy rate is higher than the so-called (activity) neutral rate, which is therefore in focus now.

The unpleasant thing about this exercise, however, is that no one really knows what the neutral interest rate is. The latest research indicates that it is probably around 3.5% in the US and 2.25% in the Euro area. But the real world is unpredictable, and the central banks must therefore feel their way forward step by step and make their decisions on a meeting-by-meeting basis on the basis of economic developments.

Of course, there is a certain risk of making mistakes along the way, but the journey towards a neutral level has begun, and right now the financial markets expect the major central banks to have completed it by the end of 2025. This means that we can look forward to interest rates below 2% in Denmark, as the Danish central bank, due to its fixed exchange rate policy, follows the ECB through thick and thin, unless something completely unpredictable happens.

Whether this level is also neutral for economic activity in Denmark remains to be seen. Personally, I believe that the Danish economy does not need such low interest rates because the labour market is still strong and housing prices are at record highs, even though interest rates are significantly higher than a few years ago.

But one thing is certain. The fixed exchange rate policy will not be changed, so if everything gets out of hand, other means must be used to curb the development. “That's how it is”, as Margrethe Vestager once put it so aptly, although it was in a completely different context than Danish monetary policy!