Why Have Central Banks Been Slow to Cut Rates?

With expectations for multiple interest rate cuts to start the year, why have the central banks been slow to move?

In the U.S., inflation has been more persistent in a relatively strong economy. This contrasts with Canada, where economic activity has been lacklustre and there have been greater indications that inflation is cooling.¹ On June 5, the Bank of Canada became the first Group of Seven central bank to reduce its policy rate, by a quarter-percentage point. However, the central banks continue to move cautiously.

Recall the considerable criticism central banks faced for their delayed response to contain rising inflation, which they dismissed as “transitory” in 2021. After aggressively raising interest rates in 2022, they have since been careful in their monetary policy decisions. One of the main reasons behind this caution is the lessons learned from the 1970s.

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First: A Brief History

Just how bad was inflation in the 70s? It was a decade marred by persistently high inflation and high unemployment, or stagflation. In Canada, we grappled with an average inflation rate of around 8 percent, with inflation hitting two separate peaks: 11 percent in 1974 and almost 13 percent in 1981. In the U.S., inflation hit 14 percent by 1980. It was only when then-Fed Chair Paul Volcker aggressively raised the federal funds rate to 20 percent by 1981 that inflation would be contained, but this pushed the U.S. into severe recession. Canada would follow suit by hiking rates to a whopping 21 percent.²

Does today’s inflation resemble that of the 1970s? Some argue that the underlying drivers of inflation share similarities. Back then, oil price shocks and energy supply shortages played a major role, compounded by the expansive fiscal and monetary policies of the 1960s and early 70s aimed at boosting employment. When inflation peaked in 2022, many attributed it to pandemic-induced supply chain disruptions, along with overly expansionary fiscal and monetary policies in response to the pandemic. While opinions may differ on the specific drivers, it’s widely acknowledged that the slow response to curb inflation in the 1970s led to even higher interest rates and a more severe economic downturn.

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The Psychology of Inflation and Unemployment

Today, the good news is that labour markets have shown relative resilience amid moderating inflation. Traditionally, inflation and unemployment share an inverse relationship, a concept observed in financial circles by the “Phillips curve.” Periods of significant central bank-induced disinflation have often been accompanied by a recession and higher unemployment.³ While the psychological impact of inflation is undeniable — most of us have felt the pain of rising costs with essentials like groceries — consider that the impact of increased unemployment may be far more profound. Various studies suggest that higher unemployment depresses our well-being more than inflation; almost twice as much in one study and up to five times in another.4 Therefore, achieving a “soft landing” that maintains both labour and price stability is enviable — and still appears attainable.

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The Bottom Line: Patience Has Been Needed

Nevertheless, the central banks remain cautious, mindful of the past. In navigating the ongoing battle against inflation, patience has been needed — akin to many aspects of investing. Interest rates, inflation and other factors will ebb and flow over time. Nobody can accurately predict their direction; there are many variables at play. As investors, we can assess the current and anticipated levels of risk and reward based on these changing macroeconomic conditions and make adjustments where necessary. However, the fundamental principles of investing still hold true: Challenging economic periods highlight the importance of prudent investment selection, maintaining a diversified portfolio with an emphasis on quality, staying disciplined and continuing to focus on the longer term.

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^1. https://www.cbc.ca/news/politics/bank-of-canada-macklem-closer-cutting-interest-rates-1.7191597;
². https://www.bankofcanada.ca/wp-content/uploads/2023/11/remarks-2023-11-22.pdf#chart6;
‍³. https://www.reuters.com/business/retail-consumer/fed-needs-recession-win-inflation-fight-study-shows-2023-02-24;
‍⁴. https://www.wsj.com/articles/inflation-and-unemployment-both-make-you-miserable-but-maybe-not-equally-11668744274

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