Markets reacted strongly and positively to the Federal Reserve policy meeting this week. “Plunged” is usually a word bandied about hyperbolically by sensationalist headline writers; however, it is not far from the truth that since peak wall-of-worry less than two months ago, the steep falls in US, German and UK government bond yields justifies the “plunge” description; if the opposite of “plunged” is “rocketed”, that is what has happened to bond prices as the corollary to falling yields (in the past 10 years the only time of comparable magnitude in bond price and yield change in a very compressed period was the few weeks leading up to the combined central banks’ actions to steady markets at the beginning of the pandemic in 2020).

With interest rates being held flat against the most recent inflation data that continued its sideways trend of the past 6 months (headline CPI 3.1% down from 3.2%, core inflation excluding food and fuel remaining at 4%), all the anticipation was generated by the accompanying commentary. The nuance was that the Fed is now considering the timing of interest rate cuts next year, shifting away from maintaining them on hold for the foreseeable future. Chairman Powell still worries about US wage inflation but senses the worst of the pressure is over. Is he coming under pressure politically to ease the cost of capital burden for borrowers as we approach an election year? Almost certainly. It would not be the first time. It sticks in our mind that when he was standing for reappointment in November 2021 and the US mid-terms were in the offing, Biden figuratively knee-capped Powell telling him to get a grip on inflation or clear out of the Fed and make way for someone who would.

Whether Powell asserts his independence and resists the pressure remains to be seen. It will be evident in the timing of prospective cuts: unless there is a sudden dramatic change to the economic data pointing to strong evidence of medium-term price stability and the 2% inflation target, the sooner he retreats from his long-held “higher for longer” position the more likely he has been susceptible to political arm-twisting. As well as economic factors, US governments seeking re-election do not like to see stock markets on a losing streak as electors contemplate which box to tick in the polling booths; it is a politically cynical reaction to the pragmatic voter’s dilemma: “do I vote for the people making me wealthier or the ones making me poorer?”. Rising markets would do nicely. We are certainly not complaining!

The Bank of England and the European Central Bank have also held interest rates steady. For the Bank, Governor Andrew Bailey insists that UK inflation is far from defeated, rates must stay high for “sufficiently long” to restore price stability. In contrast with the US policy committee which voted unanimously to hold rates and the talk was of prospective cuts, the UK Monetary Policy Committee’s was a majority decision: six in favour of holding, three insisting that rates should still rise from here. Despite the lowest inflation rate of the three jurisdictions at 2.4%, with zero economic growth and the highest unemployment, the ECB nevertheless cited eurozone unit labour costs as a medium-term inflationary concern. Judging by the response marking bond yields even lower, markets think Bailey and the ECB’s Lagarde will be smoked out of their trenches too. Where the policies of the different central banks are anticipated to diverge in terms of timing and the magnitude of changes in interest rates, that is being reflected in exchange rate differentials, already evident in the recent weakness of the US dollar (or for us in the UK, the converse, the strengthening of sterling).

There also remains the problem of debt. It is a subject we have addressed ad nauseam in these columns as western governments cynically deliver enduring deficits in their annual budgets regardless of the consequences. Taking current inflation rates and government deposit rates, for the first time in years most western governments are now experiencing positive real interest rates applied to their accumulated mountains of debt. The fiscal drag is significant especially as the negative cost of the interest rate being greater than the inflation rate more than offsets the perceived benefit of being able to “inflate away” the debt. Exemplifying the effect, UK government debt has now reached £2.6 trillion on which the estimated interest bill this financial year will exceed £95bn, £50bn more than in 2019. If “debt interest” were a government spending department, it would have the second biggest budget behind health & social care (£182bn) but well ahead of all the rest including education (£82bn) and defence (£53bn). To point out the obvious, ultimately it is taxpayers’ money which foots the government interest bill. While savers very much welcome positive real interest rates, for borrowers the opposite is true and in the worst cases is unsustainable.