Will interest rates be cut this year?

  • To understand the relationship between inflation and monetary policy
  • To discover the conundrum facing central bankers this year
  • To understand the likely path of inflation this year
Will interest rates be cut this year?

Advisers and their clients come into 2023 with their financial outlook stalked by two great challenges, the present very high level of inflation and the imminence of an economic downturn.

It is amid those twin challenges that central banks radically altered monetary policy in 2022, lifting interest rates and tapering quantitative easing programmes.

As 2023 begins, inflation has started to come down, leading to a rebound in equity markets as investors adjust their expectations around the pace and timing of interest rate rises this year, and some, including Guy Miller, head of macroeconomics at Zurich Insurance, now believe interest rates could actually be cut this year. 

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Economists tend to divide into two camps when pondering why inflation has risen so quickly, and it is in the understanding of those reasons that it may be possible to decipher the path for rates this year. 

When central banks introduced QE after the global financial crisis, there was a broad expectation that increasing the money supply so rapidly would lead to very high inflation, and that governments should respond to this by reining in their own spending.

Those who advocate the view that it is the level of money supply that is the primary or sole determinant of the level of inflation are called monetarists.

When the QE did not lead to inflation, those on the other side of the debate — known as Keynesians, and who believe that it is the velocity at which money moves through the economy that determines inflation — appeared to have been vindicated.

The onset of the pandemic and of lockdowns led to central banks instigating fresh waves of QE, and this time the inflation did happen.

How we got here 

Monetarists argue that the rise in inflation came this time because the broad money supply, that is bank lending, also rose alongside the increase in the supply of money, thanks to government-backed loan guarantee schemes.

Keynesians argue that increased government spending, including on energy price subsidies, which went directly to consumers, caused the velocity of money to rise, and it is this which caused the higher inflation. 

Higher interest rates reduce the supply of money in the economy by making it more expensive, and incentivising people and banks to hold, rather than distribute it, while also increasing the cost of existing debt, leaving individuals and companies with less cash to spend. 

So, in theory, higher interest rates reverse both the monetarist and Keynesian interpretations of why inflation rose, and inflation should fall this year, bringing forward the period when rates can start to be cut in order to deal with the recessionary conditions in the economy.